Managing Successful IT Outsourcing Relationships

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Petter GottschalkNorwegian School of Management, Norway

Hans Solli-SætherNorwegian School of Management, Norway

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Hershey • London • Melbourne • Singapore

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Acquisitions Editor: Renée DaviesDevelopment Editor: Kristin RothSenior Managing Editor: Amanda AppicelloManaging Editor: Jennifer NeidigCopy Editor: Joyce LiTypesetter: Sara ReedCover Design: Lisa TosheffPrinted at: Yurchak Printing Inc.

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Product or company names used in this book are for identification purposes only. Inclusion of thenames of the products or companies does not indicate a claim of ownership by IGI of the trademarkor registered trademark.

Library of Congress Cataloging-in-Publication Data

Gottschalk, Petter, 1950-Managing successful it outsourcing relationships / Petter Gottschalk and Hans Solli-Saether. p. cm.Summary: “This book focuses on the important issues of strategy, structure, and management of IToutsourcing relationships”--Provided by publisher.Includes bibliographical references and index.ISBN 1-59140-760-5 (hc) -- ISBN 1-59140-761-3 (sc) -- ISBN 1-59140-762-1 (ebook) 1. Information technology--Management. 2. Contracting out. 3. Electronic data processing depart-ments--Contracting out. I. Solli-Saether, Hans. II. Title. HD30.2.G676 2006 658.4'058--dc22 2005013819

British Cataloguing in Publication DataA Cataloguing in Publication record for this book is available from the British Library.

All work contributed to this book is new, previously-unpublished material. The views expressed in thisbook are those of the authors, but not necessarily of the publisher.

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Foreword ....................................................................................................................... vii

Preface .......................................................................................................................... ix

Chapter I. Introduction ...................................................................................................1Three International-Based Research Case Studies .......................................... 4

Chapter II. IT Outsourcing ..........................................................................................6Transformational Outsourcing .......................................................................... 7Outsourcing Decisions .................................................................................... 10IT Outsourcing Markets .................................................................................. 10Business Application Outsourcing ................................................................. 12Business Process Outsourcing ....................................................................... 14Maturity ............................................................................................................. 15Innovation Diffusion ........................................................................................ 18Outsourcing Definitions .................................................................................. 19Business Example: Offshore Insurance Business ProcessOutsourcing ...................................................................................................... 24Business Example: Ministry of Children and Family Affairs ......................... 25Case Study: Total Outsourcing Keeping a Strong In-houseGroup ................................................................................................................. 26

Chapter III. Some Fundamental Perspectives ............................................................. 28Value Configurations ........................................................................................ 28E-Business Infrastructure ................................................................................ 38Vendor Value Proposition ................................................................................. 52IT Function Organization ................................................................................. 57Outsourcing Performance ................................................................................ 58Successful Relationships ................................................................................. 60

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Outsourcing Opportunities .............................................................................. 60Outsourcing Threats ........................................................................................ 62Business Example: NetCom .............................................................................. 68Business Example: DuPont ............................................................................... 69Case Study: The Largest Buy-Out in Europe ................................................. 70

Chapter IV. IT Outsourcing Theories ........................................................................ 71Transaction Cost Theory ................................................................................. 71Neoclassical Economic Theory ....................................................................... 77Contractual Theory .......................................................................................... 78Theory of Core Competencies ......................................................................... 85Agency Theory ................................................................................................. 89Resource-Based Theory .................................................................................. 91Partnership and Alliance Theory ................................................................... 105Relational Exchange Theory .......................................................................... 108Stakeholder Theory ........................................................................................ 112Theory of Firm Boundaries ............................................................................ 114Social Exchange Theory ................................................................................. 117Comparison of Theories ................................................................................. 120Business Example: British Aerospace ........................................................... 120Business Example: North Cape Minerals ...................................................... 124Case Study: A Global Deal ............................................................................. 125

Chapter V. Enter Strategy ........................................................................................ 127Distinctive IT Nature ...................................................................................... 127Sourcing Alternatives .................................................................................... 129Global Outsourcing ........................................................................................ 136Strategic IT Planning ...................................................................................... 140Project Management ...................................................................................... 147Conclusions .................................................................................................... 152Case Studies: Enter Strategies ....................................................................... 152

Chapter VI. Phases and Activities ............................................................................ 155Phase 1: Vision ................................................................................................ 155Phase 2: Evaluation ........................................................................................ 156Phase 3: Negotiation ...................................................................................... 157Phase 4: Transition ......................................................................................... 158Phase 5: Improvement .................................................................................... 159

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Phase 6: Mature .............................................................................................. 162Winner’s Curse ............................................................................................... 163Conclusions .................................................................................................... 164Case Studies: Relationship Phases ............................................................... 164

Chapter VII. Contract Development .......................................................................... 168Contract Structure .......................................................................................... 168Asset Transfer ................................................................................................ 170Risk Sharing .................................................................................................... 171Technology Upgrading .................................................................................. 172Contract Duration ........................................................................................... 173Due Diligence .................................................................................................. 174Outsourcing Relationships ............................................................................ 175Relationship Management ............................................................................. 176Fee Arrangements ........................................................................................... 177Dispute Resolution ......................................................................................... 178Public Sector ................................................................................................... 180Conclusions .................................................................................................... 180Case Studies: Contract Development and Management ............................. 181

Chapter VIII. Personnel Issues ................................................................................. 184Reduction in IT Staff ...................................................................................... 184Employment Protection .................................................................................. 185Pension Considerations ................................................................................. 186Predictors of Persistent Stakeholder Expectations ...................................... 187Persistence in Managerial Expectations ....................................................... 195Transplant Perception of Role ....................................................................... 201Conclusions .................................................................................................... 202Case Studies: Transfer of IT Employees ....................................................... 203

Chapter IX. Governance Structures ......................................................................... 205Perspectives on Governance ......................................................................... 205Interaction Approach ..................................................................................... 212Management Control Systems ....................................................................... 215Performance Measurement ............................................................................. 218Partnering Relationships ................................................................................ 222Partnership Quality ......................................................................................... 223Stakeholders ................................................................................................... 227

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Hard and Soft Sides ........................................................................................ 228The IT Outsourcing Governance Model ....................................................... 230Conclusions .................................................................................................... 235Case Studies: Governance Structures ........................................................... 236

Chapter X. Costs, Benefits, and Risks ..................................................................... 239Production and Transaction Economies ....................................................... 239Hidden Costs .................................................................................................. 244Contract Termination Costs ........................................................................... 246Benefits ........................................................................................................... 247Strategic Risk Behavior .................................................................................. 249Conclusions .................................................................................................... 251Case Studies: Outsourcing Costs ................................................................. 252

Chapter XI. Knowledge Management ........................................................................ 254Intellectual Capital Management ................................................................... 254Vendor Value Proposition ............................................................................... 258Business Process Management ..................................................................... 259Knowledge Management Technology .......................................................... 260Stages of Technology Growth ....................................................................... 263Conclusions .................................................................................................... 269Case Studies: Retained Skills ......................................................................... 269

Chapter XII. Exit Strategy ......................................................................................... 271Think Exit ........................................................................................................ 271Strategic Outsourcing Termination ............................................................... 273Contract Termination ...................................................................................... 274Exit Management ............................................................................................ 276Project Management ...................................................................................... 278Conclusions .................................................................................................... 281Case Studies: Exit Strategy ............................................................................ 282

Conclusions ............................................................................................................... 283

References ................................................................................................................ 286

About the Authors ..................................................................................................... 298

Index ........................................................................................................................ 299

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In this well-timed book Petter Gottschalk and Hans Solli-Sæther methodically tackle thesubject of IT outsourcing and how to successfully manage outsourcing relationships,something that is crucial for the success of any organization. In doing so, they bringtogether their expertise as academics and researchers, along with Professor Gottschalk’senormous wealth of experience as one-time chief information officer and chief executiveofficer of several organizations.From the humble beginnings of a quarter century ago, IT outsourcing has today be-come a vast, half-trillion-dollar global industry. Gone are the days of ongoing debate onwhether to outsource IT. Today it is an acceptable fact that one just cannot buck thetide of outsourcing.Outsourcing of IT covers a range from communications network management, hard-ware/software maintenance, application management, IS management, business pro-cess outsourcing, and so forth. It represents a substantial segment of overall IT spend-ing. Yet not many executives are quite clear about the various aspects of IT outsourcingand therefore run the risk of missing out on certain business opportunities.Recent research by Gartner has revealed that satisfaction among chief informationofficers over their outsourcing contracts has dropped over the past few years. It isprimarily because they fail to understand that what, where, when, and how to outsource,and how to manage outsourcing contracts is one of the most demanding, vital, andessential business skills needed for a company’s success. Customers and suppliers arestill failing to grasp what makes for a good outsourcing relationship.This book answers the entire range of above questions in a lucid yet exhaustive way. Itcovers all aspects of outsourcing and its opportunities and threats. For practitioners, itdescribes the phases of outsourcing, details of contract development, governancestructures, costs and personnel issues, and outsourcing challenges. Further, it addsacademic rigor to its arguments by dealing with theoretical aspects of outsourcingsuch as resource-based theory and value configurations to outline how a firm can useoutsourcing to bring about fundamental strategic changes rather than just cuttingcosts and improving organizational focus.Inclusion of chapters on entry and exit strategies is notable, and will help the readersdevelop trust and good governance in their outsourcing relationships. A number ofcase studies are included to provide additional help to the reader better understand thesubject matter, and relate it to real-world scenarios.

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All in all, this book is a most comprehensive guide on all aspects of IT outsourcing, andis highly recommended for practitioners, researchers, policy makers, and consultantsalike.

Vijay KhandelwalSydney, Australia

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The market for information technology (IT) outsourcing services is growing rapidly,and costs associated with external IT services are rising in most business and publicorganizations. The reliance on outsourcing as a means of providing IT services hasbeen growing steadily over the past decade. IT outsourcing decisions are importantbecause their resolution involves significant organizational and institutional implica-tions. An urgent need for strategy and management of outsourcing has emerged.IT outsourcing is the practice of turning over all or part of an organization’s IT to anoutside vendor. Though IT may never have been more critical to business success, IToutsourcing is developing at an unprecedented rate.Even though the IT outsourcing market has grown tremendously over the past years,many organizations do not have a reflective understanding of the complex process ofIT outsourcing. The process does affect both technological and business goals andactivities, and companies must establish both strategies and structures adjusted totheir degree of outsourcing. Several critical success factors arise, and they touch uponthe relationship with internal and external stakeholders.The overall objective of this book is focus on the important issues of strategy, struc-ture, and management of IT outsourcing relationships. Using well-known theoreticalperspectives and experiences earned from several business cases, our mission is todevelop models and guidelines for the complex IT outsourcing process and emergingrelationships.The intended audience of this book includes undergraduate and graduate students, aswell as practitioners, both on the customer and vendor sides. Undergraduate studentsin management IS will learn how future IT organizations will be restructured from aresource-based perspective. Graduate students will learn how strategy will shape fu-ture sourcing, and how management roles change as sourcing strategies evolve. Ven-dors will appreciate insights into value propositions, formal agreements, and relation-ships from this book. Customers will appreciate insights into strategic choices andrelationship management from this book.Even though IT outsourcing is a practical issue, it also has significant impact on busi-ness organization theories. IT outsourcing as a discipline is based on several otherconcepts and disciplines, as well as the relations between them—international busi-ness, marketing, psychology, technology management, strategic management, projectmanagement, knowledge management, finance, economy, organizations, traditional

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management, political science, and behavioral sciences. For example, transaction costtheory is an important element in the outsourcing decision-making process. Resource-based theory of the firm, including the knowledge-based perspective of the firm, isanother example of important scholarly value, when applied to IT outsourcing models.Bringing well-known theoretical contributions together with our own business experi-ence, prior research from related fields, and new case studies of IT outsourcing, themodels and guidelines presented in this book will be a synthesis for effective learning.

Petter Gottschalk and Hans Solli-SætherOslo, Norway, October 2004

Introduction 1

Copyright © 2006, Idea Group Inc. Copying or distributing in print or electronic forms without writtenpermission of Idea Group Inc. is prohibited.

Chapter I

Introduction

Information technology (IT) outsourcing—the practice of transferring IT assets, leases,staff, and management responsibility for delivery of services from internal IT functionsto third-party vendors—has become an undeniable trend ever since Kodak’s 1989landmark decision. In recent years, private and public sector organizations worldwidehave outsourced significant portions of their IT functions, among them British Aero-space, British Petroleum, Canadian Post Office, Chase Manhattan Bank, ContinentalAirlines, Continental Bank, First City, General Dynamics, Inland Revenue, JP Morgan,Kodak, Lufthansa, McDonnell Douglas, South Australian Government, Swiss Bank,Xerox, and Commonwealth Bank of Australia (Hirschheim & Lacity, 2000).How should firms organize their enterprise-wide activities related to the acquisition,deployment, and management of information technology? During the 1980s, IT profes-sionals devoted considerable attention to this issue, primarily debating the virtues ofcentralized, decentralized, and federal modes of governance. Throughout the 1980s and1990s, IT researchers anticipated and followed these debates, eventually reachingconsiderable consensus regarding the influence of different contingency factors on anenterprise’s choice of a particular governance mode (Sambamurthy & Zmud, 2000).Today, however, there are increasing signs that this accumulated wisdom might beinadequate in shaping appropriate insights for contemporary practice. The traditionalgovernance logic has been turned upside down by utilizing other mechanisms, such assourcing arrangements, strategic alliances, roles, teams, processes, and informal rela-tionships, as the primary vehicles through which business executives orchestrate theirIT organizational architectures.Today’s IT organization must grapple with the unrelenting challenges associated withacquiring current technical knowledge; attracting, retaining, motivating, and leveragingan IT workforce; distilling the confusion amid a proliferation in IT products, services, andvendors; and contracting and managing a variety of relationships involved with selective

2 Gottschalk & Solli-Sæther


outsourcing. Increasingly, the providers of IT products and services are being viewedas both arms-length suppliers of cost-effective technology and as vibrant businesspartners with an unlimited potential to enhance a firm’s IT and business capabilities. ITprocurement has moved from being operational to tactical to strategic, amidst networksof alliances with IT vendors, consultants, and third-party service providers being builtand managed in order to leverage their associated assets, competencies, and knowledge.As the outsourcing market evolves, a number of important aspects of IT outsourcingdecisions have been explored. These studies can be categorized as descriptive casestudies and surveys of the current outsourcing practices, surveys of practitioners’perceptions of risks and benefits of outsourcing, and identification of best practices thatdistinguish success from failure (Hirschheim & Lacity, 2000). We will present many ofthese studies in this book.In general, the current research indicates that selective sourcing is still the norm but thatoutsourcing options are becoming more complex. There are many perceived benefits andrisks of outsourcing, but these studies are based on respondents’ perceptions ratherthan actual outcomes. The determinants of outsourcing research generally show thatcompanies most likely to outsource on a large scale are in poor financial situations, havepoor IT functions, or have IT functions with little status within their organizations. Thereis still considerable debate on best practices that distinguish successes from failures.Outsourcing has become popular because some organizations perceive it as providingmore value than an in-house computer center or information systems (IS) staff. Theprovider of outsourcing services benefits from economies of scale and complementarycore competencies that would be difficult for a firm that does not specialize in informationtechnology services to replicate. The vendor’s specialized knowledge and skills can beshared with many different customers, and the experience of working with so many ISprojects further enhances the vendor’s expertise. Outsourcing allows a company withfluctuating needs for computer processing to pay for only what it uses rather than to buildits own computer center, which would be underutilized when there is no peak load. Somefirms outsource because their internal IS staff cannot keep pace with technologicalchange or innovative business practices or because they want to free up scarce andcostly talent for activities with higher paybacks (Laudon & Laudon, 2005).Not all organizations benefit from outsourcing, and the disadvantages of outsourcingcan create serious problems for organizations if they are not well understood andmanaged. Many firms underestimate costs for identifying and evaluating vendors of ITservices, for transitioning to a new vendor, and for monitoring vendors to ensure thatthey are fulfilling their contractual obligations. These hidden costs can easily undercutanticipated benefits of outsourcing. When a firm allocates the responsibility for devel-oping and operating its IS to another organization, it can lose control over its IS function.If the organization lacks the expertise to negotiate a sound contract, the firm’s depen-dency on the vendor could result in high costs or loss of control over technologicaldirection. Firms should be especially cautious when using an outsourcer to develop orto operate applications that give it some type of competitive advantage. A firm is mostlikely to benefit from outsourcing if it understands exactly how the outsourcing vendorwill provide value and can manage the vendor relationship.This book consists of two parts. The first part, chapters I–IV, provides backgroundmaterial to understand and analyze the phenomenon of IT outsourcing. This part covers

Introduction 3


topics such as outsourcing definitions (Chapter II), opportunities and threats, valueconfigurations, e-business infrastructure (Chapter III), and IT outsourcing theories(Chapter IV). The second part presents key topics in managing successful IT outsourcingrelationships, as illustrated in the Figure 1.1. Managing successful IT outsourcingrelationships starts with an enter strategy and ends with an exit strategy. Foundationsfor success are phases and activities (vision, evaluation, negotiation, transition, im-provement, and performance) as well as contract development (contract structure, assettransfer, risk sharing, technology upgrading, contract duration, relationship manage-ment, fee arrangements, and dispute resolution). Chapters VI and VII serve as input tothe management of outsourcing relationships, which consist of the four elements:personnel issues, governance structures, costs, and knowledge management.In an outsourcing relationship, the vendor and the client need to transfer, exchange, anddevelop knowledge on a continuous basis. All services delivered, received, and evalu-ated are based on an exchange of knowledge between vendor personnel and clientpersonnel. If this knowledge exchange is poorly structured or completely unstructured,then misunderstandings leading to poor service quality will occur. On the other hand,if vendor and client both have installed modern knowledge management, then servicedelivery and improvement will be both efficient and effective. The importance ofknowledge exchange in managing successful IT outsourcing relationships has led us toinclude a whole chapter on knowledge management at the end of this book. Theimportance of this chapter on knowledge management will also be evident as we discussthe vendor value proposition. The vendor value proposition may consist of complemen-tary competencies such as personnel development, methodology development, andclient relationship management. Knowledge management is a key enabler of growingcomplementarities and expanding competencies.

Figure 1.1. Key topics of managing successful IT outsourcing relationships

Chapter VII PERSONNEL ISSUES

Chapter IX COSTS

Chapter VIII GOVERNANCE STRUCTURES

Chapter X KNOWLEDGE MANAGEMENT

Chapter V PHASES AND ACTIVITIES

Chapter VI CONTRACT DEVELOPMENT

Chapter IV ENTER STRATEGY

Chapter XI EXIT STRATEGY



Using well-known theoretical perspectives and experience gained from several businesscases, our mission is to develop models and guidelines for the complex IT outsourcingprocess and emerging relationships. This is done throughout the book. To highlight ourrecommendations, we end Chapters V to XII with a conclusions section, where we expressour own opinions for managing successful IT outsourcing relationships.

Three International-BasedResearch Case Studies

In order to understand the inherent complexities and the underlying constructs ofmanaging successful IT outsourcing relationships, empirical research was need. Theexploratory case studies, conducted in July–September 2004, had the following guidingresearch question: “How do client and vendor organizations manage their IT outsourcingrelationships?”The selection of cases was based on an instrumental approach, which means that the casestudy was carried out to provide insight into issue or refinement of theory. “The caseis of secondary interest; it plays a supportive role, facilitating our understanding ofsomething else. The choice of case is made because it is expected to advance ourunderstanding of that other interest” (Stake, 1994, p. 237). All three cases were selectedfor their paradigmatic characteristics in terms of their outsourcing undertaking. In otherwords, the cases were selected because the ABB–IBM is a global one, the SAS–CSCcontract belong to the largest buy-outs in Europe, and the Rolls-Royce–EDS contractis mature one. All cases are unique with global client companies from different industries,and all vendor companies are global service providers. In all three international-basedcases more than a thousand employees were transferred from client to vendor organiza-tions. They provide a broad base of relationship practice, suggesting that a case in eachcompany would be of interest and value to this research study. Figure 1.2 shows somecharacteristics of the IT outsourcing relationships studied.

Figure 1.2. Three international-based case studies (source: press releases)

Client company and interviewee

Industry Origin Outsourced Start of deal

Length of deal

Size of deal

Number of people

transferred

Customer of vendor

company Rolls-Royce Power for civil

aerospace, defense aerospace, marine, and energy markets

UK Infrastructure, application support, and development

2000 (1996)

144 months $2.1 b 1,220 EDS

ABB Power and automation technologies

Switzerland Data center, infrastructure, desktop

July 28, 2003

120 months $1.1 b 1,200 IBM

Scandinavian Airlines (SAS)

Air travel and airline-related businesses

Nordic Infrastructure management, application development, and support

December 18, 2003

60 months $1.47 b 1,150 CSC

Introduction 5


Data collection was conducted through a total of 16 interviews, with questions address-ing enter and exit strategies, phases and activities, contract development, personnelissues, governance structures and relationship management, and knowledge manage-ment, with a strong emphasis on what characteristics influenced successful IT outsourcingrelationship. For each client–vendor outsourcing relationship, two to three intervieweeswere selected from each organization. Interviews were either personal meetings or byphone.The individual cases serve only as the evidentiary base for the study and are used solelyin a cross-case analysis. The book’s purpose is not to portray any single one of therelationships. Rather, the book synthesizes the lessons from all of them and is organizedaround the topics of Chapters V to XII. In addition, a brief context and overview aboutthe individual cases is presented as abbreviated vignettes at the end of Chapters II toIV .



Chapter II

IT Outsourcing

Given the potential headaches of managing IT, it is tempting to hand the job over tosomeone else. Indeed, outsourcing once appeared to be a simple solution to managementfrustrations, and senior management teams at many companies negotiated contracts withlarge service providers to run their entire IT functions. At a minimum, these providerswere often able to provide IT capabilities for a lower cost and with fewer hassles thanthe companies had been able to themselves. But many of these outsourcing arrangementsresulted in dissatisfaction, particularly as a company’s business needs changed. Serviceproviders, with their standard offerings and detailed contracts, provided IT capabilitiesthat were not flexible enough to meet changing requirements, and they often seemed slowto respond to problems. Furthermore, a relationship with a supplier often requiredsubstantial investments of money and time, which entrenched that supplier in thecompany’s strategic planning and business processes. The company then becameparticularly vulnerable if the supplier failed to meet its contractual obligations (Ross &Weill, 2002).Problems arose because senior managers, in choosing to outsource the IT function, werealso outsourcing responsibility for one or more of the crucial decisions they should havebeen making themselves. Companies often hired outside providers because they weredissatisfied with the performance of their own IT departments—but that dissatisfactionwas primarily the result of their own lack of involvement. In light of this track record, mostlarger companies, at least, are deciding to keep their main IT capabilities in-house. Butmany engage in selective outsourcing. Good candidates for this are commodity services,such as telecommunications, in which there are several competing suppliers andspecifications are easy to set, and services involving technologies with which thecompany lacks expertise. Unlike decisions to outsource the entire IT function, selectiveoutsourcing decisions are usually best left to the IT unit, assuming that senior manage-ment has taken responsibility for overall strategy.

IT Outsourcing 7


Beaumont and Costa (2002) studied IT outsourcing in Australia. They found that almost40% of Australian organizations outsource one or more IT applications. Large organi-zations tended to outsource more than small ones. The three most important reasons foroutsourcing were access to skills, improved quality and focus on core business. Fourfactors contributed to successful outsourcing: a tight contract, a partnership, a changeprocess, and the IT manager’s role changing from managing projects and operations toacquiring and managing the internal and external resources required to do the organization’sIT work.Successful IT outsourcing relationships enable participants to achieve organizationalobjectives and to build a competitive advantage that each organization could not easilyattain by itself. Outsourcing success can be viewed as the level of fitness between thecustomer’s requirements and the outsourcing outcomes. Outsourcing success can bemeasured in terms of both business and user perspectives. From a business perspective,outsourcing is motivated by the promise of strategic, economic, and technologicalbenefits. The success of outsourcing, then, should be assessed in terms of attainmentof these benefits. From a user perspective, outsourcing success is the quality level ofservices offered. A decision to outsource on the basis of saving costs without analysisof the quality of services frequently leads to higher costs and lower user satisfaction.Therefore, it is imperative to conduct a proper analysis of the service quality beforebuilding a relationship with a service provider for a successful outsourcing arrangement(Lee & Kim, 1999).

Transformational Outsourcing

The traditional way of thinking in IT outsourcing is to move the current IT function outof the organization and let another organization handle it. There is no strategic thinkingbehind it, except the idea of solving a problem, saving some money or improving afunction by means of some undefined solutions. The new way of thinking is to make IToutsourcing part of a strategic transformation of the IT function, where new tasks androles are implemented to replace old tasks and roles. A classic example of this new wayof thinking is the transformation of the IT function at British Petroleum (BP) in the 1990s.The IT function went through a fundamental transformation consisting of the followingchanges (Cross, Earl, & Sampler, 1997):

• From systems provider to infrastructure planner. The mission of the IT functionshifted from developing systems to overseeing technical integrity and pursuingvalue creation and cost-reduction opportunities through information sharing.

• From monopoly supplier to mixed sourcing. In 1991, outsourcing of operations,telecommunications, systems development, and IT maintenance began, as BPrecognized that it was not essential that these were carried out in-house. Some localsites already had experience in facilities management, and as contracts came up forrenewal, lessons were recorded and a worldwide outsourcing program was imple-mented.



• From business standards to industry standards. IT managers have long beenconcerned about coordinating various types of computing and communicationequipment. However, throughout most of the research on IT infrastructure, thefocus has been directed at creating and managing the internal infrastructure.Therefore, BP spearheaded a unique initiative to help create an external softwaremarket by being one of the early advocates and founding members of thePetrotechnical Open Software Corporation, which was joined by a number of oilcompanies such as Elf, Mobil, Statoil, and Texaco.

• From decentralized bias to centralized top sight. The senior management teamrealized that the major benefit of centralized management of IT is not budgetauthority, but is in setting standards for infrastructure. While some IT resourcesstill remain in the local businesses, it is the job of the top IT management team toprovide the global perspective for infrastructure planning and cost control, whichis here called top sight.

• From systems analysts to business consultants. A new skill set was defined for ITpersonnel. The new skill set has an equal balance between business, technical, andpeople skills. Such a radical change in the skill set of IT staff has been supportedby a number of human resource initiatives such as skills testing, self-assessment,and personal development planning.

• From craftsmen to project managers. IT personnel no longer approach their job ascraftsmen, viewing each job as a unique, customized process. Their task hasswitched to that of project managers, integrating and coordinating stakeholdersinvolved in providing IT applications and operations.

• From large function to lean teams. Team orientation was stimulated in differentways. For example, staff was moved around the world to create global not localloyalties. A team-building and team-working program was introduced stressing theuse of multifunctional teams and diluting the functional focus.

The IT budget was reduced from $360 million in 1989 to $132 million in 1995 after thistransformation. IT personnel were reduced from 1,400 persons to 150 persons in thesesix years. Hence, a large portion of the reduced IT budget went to external outsourcingvendors. As this pioneering case of IT outsourcing illustrates, outsourcing can be morethan a tool for cutting costs and improving organizational focus. Increasingly, it is ameans of acquiring new capabilities and bringing about fundamental strategic andstructural change.According to Linder (2004), the concept of transformational outsourcing is an emergingpractice, where companies are looking outside for help for more fundamental reasons—to facilitate rapid organizational change, to launch new strategies, and to reshapecompany boundaries. In doing so, they are engaging in transformational outsourcing:partnering with another company to achieve a rapid, substantial, and sustainableimprovement in enterprise-level performance.Transformational outsourcing places the power to bring new capabilities to the organi-zation squarely in the hands of executives who have and value those capabilities. In otherwords, the outsourcing partner provides a management team that is experienced in the

IT Outsourcing 9


capability that the organization seeking change needs. And those executives areempowered by the outsourcing process to implement the practices they bring with them.Not all transformational outsourcing initiatives are alike. Linder (2004) identified fourbroad categories from her research on 20 companies that have attempted the practice. Thefour categories are start-ups (outsource to rapidly scale up a new business), pathway togrowth (outsource to fix a key process that stands in the way of growth), change catalyst(outsource to signal broad change and focus on adding value), and radical renewal(outsource to improve core operating capabilities radically).As executives obtain more experience with outsourcing, they are learning the tool’spotential and beginning to wield it for more strategic purposes. Some will use it to shapeand reshape their business models. Instead of massive, sweeping changes, manyorganizations will master the ability to use outsourcing to make continuous incrementalimprovements. But while the potential benefits are incontrovertible, the art of joiningorganizations with unique capabilities is extremely challenging and requires visionaryleaders with strong hearts and a large capacity for hard work. By combining the tool’sexecution effectiveness with their own growing skills in partnering, leaders who displaythose characteristics will have a practical and realistic road map at their disposal forbuilding strategic flexibility.Transformational outsourcing is an emerging practice, but the track record of companiesthat have engaged in it is impressive. In a study of 20 companies, 17 of them have beenin place long enough to show results. Of that group, 13 have achieved dramatic,organization-level impact. To the extent that other companies can replicate such success,transformational outsourcing may become a more effective way of improving perfor-mance than major internal change initiatives, mergers and acquisitions, or joint ventures(Linder, 2004).The key issue is new capabilities. In undertaking an internal initiative, a company hasconcluded that it lacks an important set of skills, otherwise it would not be seekingtransformation. But it often proves too time consuming to develop the skills internally.In a mergers-and-acquisition scenario, the company acquires the capabilities it lacks, butcultural clashes often interfere with its ability to use them effectively. An acquiringcompany seldom, for example, puts executives from the acquired company in charge ofits own organization in order to learn from them. Similar cultural impediments make itunlikely that a company will transform itself with the expertise it gains in a joint venture.But transformational outsourcing places the power to bring new capabilities to theorganization squarely in the hands of executives who have and value those capabilities.The outsourcing partner provides a management team that is experienced in thecapability that the organization seeking change needs. And those executives areempowered by the outsourcing process to implement the practices they bring with them.Transformational outsourcing is concerned with bringing new capabilities to the orga-nization through important sets of skills. These skills can be found in knowledge work,and knowledge management emerges as an important discipline in transformationaloutsourcing. Executives have to lead a transformational outsourcing initiative muchdifferently from the way they would manage conventional outsourcing.



Outsourcing Decisions

The decision to outsource or insource enterprise-wide activities related to the acquisi-tion, deployment, and management of IT represents one of the more complex choicesfacing a firm’s managers. On the one hand, insourcing requires management to commitsignificant resources to a course of action, the effects of which may be costly to reverse,while forgoing numerous advantages associated with the marketplace. On the otherhand, insourcing may be required for a firm to accumulate resources necessary togenerate or maintain a competitive advantage.The complexity of this decision is demonstrated in research conducted by Leiblein,Reuer, and Dalsace (2002). They examined the relationship between governance choiceand technological performance. In contrast to popular arguments suggesting thatinsourcing or outsourcing will lead to superior technological performance, they foundthat governance decisions per se do not significantly influence technological perfor-mance directly. Rather, observed differences in the performance of transactions gov-erned by different organizational forms are driven by factors underlying governancechoice. While the increasing rapidity of technological change and the increasingdispersion of knowledge suggest an increased role for outsourcing in the economy, therelationship between governance choice and performance is dependent on the distribu-tion of relevant capabilities and the degree to which performance is driven by autono-mous or systemic innovation.Empirical evidence suggests that carefully crafted outsourcing strategies increase theoverall performance of the firm. Outsourcing is generally considered as a very powerfultool to cut costs and improve performance. Through outsourcing, firms can takeadvantage of the best outside vendors and restructure entrenched departments that arereluctant to change. Outsourcing can also help focus on the core business. Sincebuilding core competencies and serving customer needs are critical to a firm’s success,anything that detracts from this focus may be considered for outsourcing (Barthélemy,2003b).The decision to outsource is influenced by a number of factors. In this book, we willdiscuss factors such as production economies, transaction economies, technologicaluncertainty, functional complexity, transaction-specific investments, supplier presence,slack resources, and criticality of IT. Many more factors will be presented.

IT Outsourcing Markets

Research on global computing services shows that there has been a massive growth inthe number of large outsourcing deals signed in continental Europe. The GlobalComputing Services’ contracts database tracks all outsourcing, integration, and consult-ing deals with a value greater than $1 million, and in the major part of 2003, it tracked $21.32billion of deals in the region —a huge 173% increase on the $7.81 billion deals trackedin 2002. This made continental Europe the fastest growing territory for major IT services

IT Outsourcing 11


deals in 2002, ahead of the U.K., which showed a 110% increase. The value of the 10 largestoutsourcing deals in continental Europe is listed in Table 2.1 (as of December 11, 2003).Another good indicator of the health of the outsourcing market across various geogra-phies is to look at the number of IT services deals signed with a value greater than $100m—almost all of which are long-term outsourcing deals. There has been a huge surge inthe number of these mega-deals in continental Europe during 2003. Global ComputingServices has tracked 46 contracts with a value of $100 million or more in 2003, comparedto just 13 in 2002. The number of mega-deals increased by 27% in the rest of the world,by 14.5% in the United States, and by 6.4% in the U.K. The growth in the market for ITservice deals is shown in Table 2.2.The outsourcing market can also be studied in terms of industries. For example, thehealthcare industry in the United States was studied by Lorence and Spink (2004). Theyfound that IT functions in healthcare organizations most likely to be outsourced toexternal vendors or consultants were transcriptions (patient data) and microfilming.Overall, nonmanagement IT functions were more likely to be outsourced, especiallywhere more use of computerized patient data results in increased demand for IToutsourcing. The impact of organizational factors in outsourcing preferences alsosuggested that outsourcing decisions, rather than being function specific, might be theresult of a more general level of comfort for outsourcing across the organization as awhole.There seems to be some key forces shaping the outsourcing market. According toconsulting organization Gartner (2004a), real-time delivery offerings require major shifts

Table 2.1. The 10 largest outsourcing deals in continental Europe in 2003(ComputerWire, 2003)

Rank Vendor Client Project Region Value Length Date 1 IBM Global Services Nordea Bank Infrastructure management,

Server management, Desk-top management

Sweden $2.66 b 120 months October 1, 2003

2 T-Systems Daimler-Chrysler Network management, Infrastructure management, Desktop management

Germany $1.40 b 36 months August 11, 2003

3 IBM Global Services ABB Data center outsourcing, Infrastructure management, Desktop management

Switzerland $1.10 b 120 months July 28, 2003

4 IBM Global Services AXA Sun Life Infrastructure management, maintenance/support, server management

France $1.00 b 72 months February 27, 2003

5 IBM Global Services M-Real Application development and support, Infrastructure management

Finland $645.8 m 120 months June 11, 2003

6 Hewlett-Packard Bank of Ireland Desktop management, Server management, Infra-structure management

Ireland $600 m 84 months November 28, 2003

7 EDS Corp. Ministry of Flemish Community

Network management, application development and support

Belgium $513 m 60 months June 27, 2003

8 Computer Sciences Co. ISS AS Infrastructure management, Network management, Desktop management

Denmark $450 m 120 months May 27, 2003

9 IBM Global Services Lego Company Infrastructure management, Computer engineering, Maintenance/support

Denmark $400 m 60 months August 11, 2003

10 IBM Global Services Banco Comercial Portugues

Infrastructure management, Business continuity/disaster recovery

Portugal $391 m 120 months July 4, 2003



in outsourcing contracting models, including financing, pricing, service levels, assetmanagement, risk management, and standards. A long-term development road map forreal-time infrastructure and real-time delivery can be essential for competitive differen-tiation in outsourcing. For example, outsourcing vendors must optimize the managementand financing of IT assets to deliver the on-demand, pay-per-use promises of real-timedelivery. IT infrastructure consolidation and standardization characterized the largestmultibillion dollar IT outsourcing contracts during 2003 and are expected to continue forseveral years. These outsourcing contracts are not just exercises in cost reductionnecessitated by economic problems, but they are also intended to advance the clientstoward becoming real-time enterprises through the benefits of emerging real-timeinfrastructure and real-time delivery services. Gartner defines a real-time enterprise as anenterprise that competes by using up-to-date information to progressively removedelays to the management and execution of its critical business processes.

Business Application Outsourcing

Dramatically reduced network cost due to the Internet and virtual private networks, theever-increasing supply of bandwidth, and advances in the security of Internet-basedtransactions have led to the emergence of application service providers (ASPs), a newcategory of IT service firms. An ASP can be defined as an organization that manages anddelivers application capabilities to multiple entities from a data center across a wide areanetwork. User organizations can access software applications from one or more ASPsover the Internet for a subscription fee (Susarla, Barua, & Whinston, 2003).In a typical business, we find several IS applications. For example, Weill and Vitale (1999)identified an applications portfolio of 18 systems in a manufacturing business: budget-ing, capital projects, customer complaints, debtors, general ledger, freight cost manage-ment, fixed assets, human resource management, inventory, market data, multiplantaccounting, office support, payroll management, pricing and sales, purchasing, salesforecasting, product safety system, and trading accounts management. These systems

Table 2.2. Growth in IT service deals by region between 2002 and 2003 (ComputerWire,2003)

Continental Europe

United Kingdom

United States

Rest of the World

Value of contracts in 2003 (to December 11)

$21.32 b $23.65 b $44.74 b $10.53 b

Value of contracts in 2002 (full year)

$7.81 b $11.27 b $42.05 b $14.32 b

% Change +173% +110% + 6.4% ? 26.5% Number of $100 m+ contracts in 2003

46 33 95 28

Number of $100 m+ contracts in 2002

13 31 83 22

% Change +254% +6.4% +14.5% +27%

IT Outsourcing 13


support tasks in peoples’ jobs. For example, all systems help planning, investigating,coordinating, evaluating, supervising, staffing, negotiating, and representing to avarying extent.User organizations can access software applications from one or more ASPs over theInternet for a subscription fee. A key selling point for ASP services involves a shortertime period required to implement new software applications. For businesses plagued byhigh turnover of IT staff, inadequate organizational resources to maintain and upgradeexisting IT applications, and large capital requirements for major IT implementationprojects, the ASP business model could be an attractive alternative with its off-the-shelfIT applications subscription approach. Sophisticated ASPs have gone as far as offeringenterprise resource planning, e-commerce, and supply-chain applications, which mayinvolve integration with existing IS in a user organization (Susarla et al., 2003).While the ASP model has the potential to fundamentally change the manner in which ITservices are provided to user firms, to date ASPs have had a limited success in signingup customers. Moreover, several customers of ASPs are unsatisfied with their service,which questions the viability of the ASP business model and selection of ASP as an enterstrategy for IT outsourcing. Evidence also points to the fact that ASPs themselves haveto rework their service strategies in response to market demand. It has long beenrecognized that market success depends on designing services to match customer needsand that customer satisfaction has a positive impact on market share and profitability.Satisfied customers are more likely to engage in positive word of mouth, thus loweringthe cost of attracting new customers. Satisfaction based on successful exploration andexploitation of the vendor value proposition plays an important role in building otherimportant assets for the firm. A focus on satisfaction is important for ASPs if they haveto retain existing customers as well as attract new customers (Susarla et al., 2003).This calls for an assessment of the determinants of client satisfaction with ASPs andevaluation of the effectiveness of the ASP mode of service delivery over the Internet.Susarla et al. (2003) analyzed the determinants of satisfaction in ASP service provision.Their analysis shows that the satisfaction with an ASP is negatively affected by thedisconfirmation effect, but positively influenced by the perceived provider performanceand prior systems integration, which is a measure of integration of organizationalsystems prior to using ASP services. Disconfirmation is the negative discrepancybetween expectation and performance.Further, perceived provider performance is positively influenced by the functionalcapability of the ASP and the quality assurance by the ASP, but negatively influencedby the prior systems integration. These findings suggest that, to be successful, ASPsmust strive to reduce the disconfirmation effect faced by adopting organizations and toenhance the perceived quality of their solution, possibly through partnerships withleading IT vendors. Further, ASPs must improve the integration of their offerings withexisting applications in user organizations, which may require alliances with IT firms thatspecialize in integration services. From a client perspective, an enter strategy of ASPselection may thus focus on integration with existing IT, performance delivery, andstandards of software capability. From a vendor perspective, the findings of Susarla etal. (2003) indicate a need for ASPs to facilitate integration with existing IT in clientorganizations, ensure superior performance delivery, emphasize rigorous enforcement



of service agreements, and ensure that their application meets standards of softwarecapability. Their finding that ASPs are not evaluated on some of the prior experiencesof the organizations is favorable to vendors, since it suggests that firms that are Internetsavvy or that have a strong IT department are not going to have unreasonably highexpectations from the ASPs.A related area of exploration is an analysis of how organizational users form expectationsabout an ASP’s services. The literature on outsourcing posits that the trade press,discussion with peers, consultants’ forecasts, and the business strategy pursued by thecompany can contribute to the formation of expectations in the outsourcing context. Asthe IT outsourcing literature has documented, management defines the scope of theoutsourcing and the sourcing criteria, while the IT department can provide insights intothe technological reasons for outsourcing and judge the success of the outsourcingproject in terms of performance outcomes that are met. Expectations that need to berealized in the outsourcing context may reflect the consensus among the differentstakeholders in the organization (Susarla et al., 2003).

Business Process Outsourcing

Enterprise restructuring is expected to provide fertile ground for outsourcing in thebusiness process outsourcing market segment. Some companies turn to outsourcing tofoster change management during consolidation and integration. Consolidation, merg-ers and acquisitions result in integration needs for back-office processes, which are oftenmet by outsourcing. Divested companies need to grow entire back-office functions fromscratch and look to external services providers to provide this process-managementcapability. Business process outsourcing includes enterprise services (human re-sources, finance and accounting, payment services, and administration), supply man-agement (buying processes, storing processes, and moving processes), demand man-agement processes (customer selection, customer acquisition, customer retention, andcustomer extension), and operations. A typical business process outsourcing contractincludes discrete project-based IT services, ongoing IT management services, andgeneral process management (Gartner, 2004b).Business process outsourcing often fills human resources (HR) practitioners with fear,but handled properly, it can help the HR function become more efficient and strategic.Of all the business-related acronyms that are filtering through to the corporate con-sciousness, BPO (business process outsourcing) is certainly one that appears to beraising interest. BPO, although often seen as the next evolutionary step in IT outsourcing,is also very different from it. BPO is about delegating the ownership, administration, andoperation of a process to a specialist third party in order to solve a business problem.And because BPO is about delivering outcomes—higher-performing business pro-cesses—it aims to raise a client company’s shareholder value (Strategic HR Review,2004).Business processes within a company can be broken down into three categories: core;business critical noncore; and finally noncore, noncritical. Core processes are seldom

IT Outsourcing 15


outsourced, because they are the very essence of the business and the area that requiresthe most investment. Critical and noncritical noncore processes may be suited foroutsourcing to a third-party supplier who will invest in them on the company’s behalf.Process management has the highest expected growth rate in outsourcing. Businessprocessing outsourcing is typically the outsourcing of a company’s noncore or back-office business processes. Usually those processes are (or should be) IT enabled andhence can be transformed by the use of a new or improved technology platform. Theappeal of BPO is that it attempts to involve a new support services model involving cost-effective, scalable, efficient services. The growth in demand for process outsourcing hasalso seen an expansion in the range of services being provided by suppliers. Processestypically outsourced include finance and accounting, procurement, human resources,and real estate (Honess, 2003).

Maturity

For most firms, becoming a real-time enterprise is an evolutionary development. Earl(2000) has described the typical six-stage journey that corporations are likely toexperience. The six stages are not necessarily definitive periods of evolution, ascompanies may have activities at several neighboring stages at the same time. The sixstages are illustrated in Figure 2.1.

1. External communication. It was more than a decade ago that most corporationswanted a home page on the Internet for the first time. The realization that theInternet was a potential communications channel to external stakeholders, such asinvestors, analysts, customers, potential recruits, and suppliers, was matched bythe recognition that the Web provided an interesting and not-too-difficult meansof designing and publishing corporate public relations material. The vision behind

Figure 2.1. Stages of e-business maturity

EXTERNAL

YEARS

II

I

III

IV

VI

V

E-COMMERCE

INTERNAL

E-BUSINESS

E-ENTERPRISE

TRANSFORMATION

E-MATURITY



creating such Web sites rarely extends beyond external corporate communica-tions. Perhaps the only interactive aspect is a provision for e-mailed questions tocorporate departments from external stakeholders.

2. Internal communication. Intranets, using the Internet and Web techniques, areintroduced at this stage to raise the information and communication capacity of theorganization. An integrated, familiar front end to frequently used internal applica-tions does appeal to end users. Knowledge management applications have evolvedfrom this stage. And sometimes having internal access to the same information thatis provided externally is well received.Information technology is applied to design consistent and user-friendly frontends to e-mail, groupware, administrative support systems, and other systemsused by most people in the organization.

3. E-Commerce. Buying and selling on the Internet take place at this stage. Electronicchannels and services are promoted to complement traditional forms of distribu-tion. In the case of start-ups, customers are identified and attracted by using theWeb and other advertising channels. At this stage, organizations struggle withquestions such as “What and how do we tell customers and suppliers that they cantrade with us online?” “What pricing policies do we adopt and how do they relateto pricing in our traditional channels?” “Which products and services are suitedto electronic market trading?” “What IS/IT applications and functions are neededto support e-commerce?”

4. E-Business. Many companies discover a critical lesson at the e-commerce stage.Building an online channel on top of inadequate or inefficient business processesachieves only one thing: it broadcasts and magnifies the fact that the company’sback-office systems or operational processes are really bad. So this fourth stageis about reengineering and redesigning business processes to match customers’expectations.Customers already recognize the signs of business processes that are not synchro-nized with the demands and expectations of e-commerce: goods that do not arriveon time; e-mailed requests that do not receive response; clumsy handling ofreturns; inability to track order status; network access that breaks down; andtelephone requests where persons answering the phone have no idea what you aretalking about.Most firms learn the hard way and treat stage 3 as inevitable, evolutionary,experiential learning. Then they accept the costs of stage 4, where reengineeringof business processes and redesign of architecture and infrastructure of theirtechnology base have to be implemented. The lesson at stage 4 is that high-performance processes are needed to stay in e-business.

5. E-Enterprise. Web-enabled online business puts new pressures on managementprocesses. Decision making occurs increasingly on the network, rather than inmeeting rooms. Transactions can be monitored and analyzed in real time. Informa-tion can be collected online. New ways of representing and analyzing these dataare being developed. We are witnessing new ways of communicating across theenterprise using wireless and mobile technologies.

IT Outsourcing 17


Wireless and mobile technologies are about to change Internet business. This isbeing driven by customer demand for wireless devices and the desire to beconnected to information and services available through the Internet from any-where and at any time. Similarly, company employees see no reason anymore forshowing up in the office at 8 a.m. and leaving at 5 p.m. As a result, telecommuni-cations, the Internet, and mobile computing are merging their technologies to formthe basis for mobile work and management.In stage 5, decision-making is becoming entrepreneurial and about communicatingdecisions across the enterprise. This stage is where traditional top managers findthe time to leave the company. The critical success factor is to recruit, develop, andempower people who have the skills to use information and act on it.

6. Transformation. The company has successfully made the journey of e-business.The challenges of the previous stages have been met, and the new business andmanagement solutions required for the e-enterprise are embedded. In many ways,this is the goal. However, we know that market forces and emerging technologiesdrive continuous change.

As firms develop into real-time enterprises, real-time infrastructure becomes critical.Real-time infrastructure is a distributed computing model where infrastructure is sharedacross customers and dynamically optimized to achieve end-to-end service levels at thelowest price. Where resources are constrained, business policies determine allocationof resources to meet business goals. Real-time infrastructure services from an outsourcingvendor has the potential of significantly reducing the costs associated with IT servicesassurance while simultaneously improving quality of service and agility and adaptabil-ity. Therefore, its adoption is inevitable. Enterprises and external service providers arebuilding real-time infrastructure. Real-time delivery is the packaging, pricing, andrelationship engagement model for services based on the real-time infrastructure. Real-time delivery offerings do not require the full development of a real-time infrastructure.Claims processing, travel reservation systems, mainframe computer time sharing, andother service offerings making use of standardized, optimized architectures and pay-per-use or unit of service are well within the genealogy of real-time infrastructure and real-time delivery. Examples of current offerings include application services, hosting, andstorage utilities and communications services. The emergence of real-time infrastructureand real-time delivery signals the maturation of IT outsourcing, moving from a custom-ized to a mass-customized delivery that shifts the emphasis for customized services fromIT infrastructure to business processes. The focus of cost reduction because of the weakeconomy and the growing disenchantment with the return on investment from ITinvestments are contributing factors to this shift.Based on this analysis, Gartner (2004a) considers the IT infrastructure marketcommoditized and mature to the extent that the IT infrastructure is consolidated andstandardized to obtain real-time infrastructure characteristics. Real-time infrastructurehas the potential for offering lower costs, higher quality of service, and agility to changethe allocation of the infrastructure to meet changing business priorities. The goal is tomake the infrastructure utility like, so that it can support any application or businessprocess. A conservative estimate for the extent of commoditization of adoption of real-



time delivery offerings is about 5% of the total IT infrastructure outsourcing market. Thisis conservatively forecast to grow to about 20% within the next five years. Liberalestimates would be 10 to 30%.BPO is the factor likely to have the greatest influence on commoditization and maturityof IT infrastructure outsourcing. BPO may largely eliminate the IT element in decisionmaking for business unit managers and corporate-level executives looking for costreduction. Enterprises are more likely to have separated IT and business processcontracts than a business process contract that subsumes IT, but this is expected to shiftover time with BPO maturity. Anticipating this shift in focus to business process level,outsourcing vendors such as EDS, HP, and IBM have already developed strategies basedon emerging real-time infrastructures and real-time delivery offerings that are positionedas enablers of real-time enterprise. Each vendor has developed its own vision for real-time infrastructure, delivery, enterprise, and template, and branded its vision as followsin 2004: Agile Enterprise (EDS), Adaptive Enterprise (HP), and On Demand Business(IBM). These brands reflect a focus on business value instead of technical value. As ITinfrastructure services commoditize and mature, value shifts upward to the businessprocess level. Real-time delivery offerings, whether end-to-end or point solutions,require major shifts in outsourcing contracting models, including financing, pricing,service levels, asset management, risk management, and standards.

Innovation Diffusion

There are several theoretical approaches to understanding IT outsourcing. One suchapproach is innovation diffusion theory. Innovation diffusion is defined as the processby which an innovation is communicated through certain channels over time among themembers of a social system. Four key elements determine the characteristics of thediffusion process of an innovation: innovation, time, social system, and communicationchannels. An innovation is any idea, object, or practice that is perceived as new by themembers of a social system. Time relates to the rate at which the innovation is diffusedor the relative speed with which it is adopted by members of the social system. The socialsystem consists of individuals, organizations, or agencies that share a common cultureand are potential adopters of the innovation. Communication channels are the means bywhich information is transmitted to or within the social system (Ho, Ang, & Straub, 2003).Examining the adoption of IT outsourcing from the theoretical foundation of innovationdiffusion may shed some light on significant factors that affect the adoption decision andclarify misperceptions. For example, a study by Hu, Saunders, and Gebelt (1997) examined175 firms that outsourced their IT functions, and they tested three hypotheses of sourcesof influences using four diffusion models: internal influence, external influence, and twomixed-influence models. A mixed-influence model represents the combined effects ofexternal media, vendor pressure, and internal communications at the personal levelamong managers of companies that significantly influenced the decision to adopt ISoutsourcing. Their findings suggest that the mixed influence is the dominant influencefactor in the diffusion of IT outsourcing, and that there was no evidence of the effects

IT Outsourcing 19


from early outsourcing cases (which has been labeled the Kodak effect) in the IT diffusionprocess. This directly contradicts the conclusion of earlier studies, where the Kodakeffect argued that Kodak’s highly publicized decision to outsource its IT was the pointat which the internal influence model became dominant.Diffusion models have many underlying assumptions which may or may not be satisfiedunder the conditions of IT outsourcing. Awareness of these limitations will certainlyassist in the interpreting of statistical results, as well as in generalizing the conclusions.For example, models permit only one adoption by an adopting unit, and no rescindingof the adoption. That is, once a company outsources it does not insource again.Furthermore, innovation models are typically based on a distinct and constant ceiling.That is, the potential number of adopters in a social system does not increase or decreaseduring the diffusion process.One of the things that are underappreciated is the amount of innovation that goes onthroughout organizations following the introduction of new technology. Technologytypically makes a lot of information available to people at a very low cost. Managementwants to encourage people to find new ways of using that information. However,companies that are managed in a top-down, hierarchical manner will be disadvantaged.Employees will be discouraged from the very experiments that can lead to importantproductivity gains. The way companies treat employees seems to have an importantimpact on their ability to get the most innovation out of IT investments (Financial Times,2004).

Outsourcing Definitions

If a firm does not want to use its internal resources to build or operate IS, it can hire anexternal organization that specializes in providing these services to do the work. Theprocess of turning over an organization’s computer center operations, telecommunica-tions networks, and/or applications development to external vendors is called outsourcing(Laudon & Laudon, 2005).Loh and Venkatraman (1992a) define IT outsourcing as the significant contribution byexternal vendors in the physical and/or human resources associated with the entire orspecific components of the IT infrastructure in the user organization. Vendors maycontribute computer assets for the user from outside the organization. Alternatively, theownership of certain computer assets of the user may be transferred to the vendor.Similarly, vendors may utilize their personnel to provide the required services, or thevendor may employ existing staff of the user. In their research, they attempted to explainthe degree of IT outsourcing by using cost structures and economic performance. Theyfound that the degree of IT outsourcing is positively related to both business and IT coststructures, and negatively related to IT performance. IT outsourcing was framed as amake-versus-buy decision, where contractual modes differ in the domain of influencewithin the corporation (Loh & Venkatraman, 1992a, 1992b).Lacity, Willcocks, and Feeny (1996) define outsourcing to dismantle internal IT depart-ments by transferring IT employees, facilities, hardware leases, and software licenses



to third-party vendors. Hirschheim and Lacity (2000) define information technologyoutsourcing as the practice of transferring IT assets, leases, staff, and managementresponsibility for delivery of services from internal IT function to third-party vendors.Grover, Teng, and Cheon (1998) define outsourcing of IS functions as the organizationaldecision to turn over part or all of an organization’s IS functions to external serviceprovider(s) in order for an organization to be able to achieve its goals. This decision-making approach is interesting because it focuses on an early stage of a long process.Resource-based theory and resource-dependence theory from the field of strategicmanagement and transaction cost theory and agency theory from economics are usedin order to describe its implications for outsourcing research and practice. The definitionincludes decisions about how to arrange external IT services. Using several theoreticalperspectives of outsourcing, they presume that organizations attempt to make thesedecisions in their best interests. Similarly, Grover, Cheon, and Teng (1996) defineoutsourcing as involving a significant use of resources —either technological and/orhuman resources—external to the organizational hierarchy in the management ofinformation technology.Hu, Saunders, and Gebelt (1997) define IS outsourcing as a business practice in whicha company contracts out all or part of its IS operations to one or more outside suppliers.Here we find that outsourcing is a practical issue that also has a significant impact onbusiness organization. Even though outsourcing is a business practice, for IS executivesacquiring outside services is an important strategic issue confronting their organiza-tions. Thus, their theoretical perspective is strategic decision making. In their research,they have identified sources of influence in the adoption decision. One significantinfluence is the combined effects of external media, vendor pressure, and internalcommunications at the personal level among managers.Kern and Willcocks (2002) are more process oriented in their approach, focusing on thelong-term interaction. They focus on the key elements of the exchange and the relation-ship between different stakeholder groups. They recognize the influence of the environ-ment and the atmosphere in which the interaction takes place. They define outsourcingas a process whereby an organization decides to contract-out or sell the firm’s IT assets,people, and/or activities to a third-party supplier, who in exchange provides andmanages these assets and services for an agreed fee over an agreed time period. In theirprocess-oriented approach, they are using Håkansson’s (1982) interaction model toexplain the client-vendor relationship of IT outsourcing. Although Lacity and Willcocks(2000b) did not explicitly provide a definition of outsourcing, it seems that they are in linewith this process-oriented approach. They introduced a relationship framework thatfocuses on relationship stakeholders, relationship types, and six phases (scooping,evaluation, negotiation, transition, middle, and mature phase) and activities related tothese phases. In this perspective, IT outsourcing is viewed as a longitudinal processinvolving several stakeholder groups.Outsourcing can be defined as turning over all or part of an organizational activity toan outside vendor (Barthélemy, 2003b). Here outsourcing is the purchasing, from outsidethe organization, of IT services needed to perform business functions. According toLangfield-Smith and Smith (2003), outsourcing is the contracting of any service oractivity to a third party. Both definitions are concerned with the interfirm relationship,

IT Outsourcing 21


Table 2.3. Outsourcing definitions in the research literature

Literature reference

Outsourcing perspective

Theoretical perspective

Determinants of practice in IT outsourcing

Ang and Cummings (1997) Organizing for resources in an open and networked form

Institutional theory Nature of institutional pressures, perceived gain in production economics, financial capacity to resist influences, and transaction cost considerations

Ang and Straub (1998) Reliance on external service providers for IS functions

Economic theory, transaction cost theory

Production costs, transaction costs, financial slack, firm size

Ang and Slaughter (2001) Use of contractors to supplement permanent staff

Social exchange theory Contracting of information services in light of corporate downsizing and restructuring

Bahli and Rivard (2003) Turning to external suppliers in order to meet IT needs

Agency theory Risks: lock-in, contractual amendments, unexpected transition and management costs, and disputes and litigation

Barthélemy (2001) Entrust information technology activities to a third party

Economic theory Hidden costs that undercut anticipated benefits

Barthélemy (2003a) Turning over all or part of an organization’s IT to an outside vendor

Management theory Hard sides: preciseness, completeness, balance. Soft sides: relationships based on trust

Barthélemy (2003b) Turning over all or part of an organizational activity to an outside vendor

Management theory Lacking management expertise underlies most failed outsourcing efforts

Beaumont and Costa (2002) Passing IT functions previously performed in-house to outside contractors

Causal factors Access to skills, improved service quality, focus on core business, defined service levels

Cross, Earl, and Sampler (1997)

Transformation of IT functions

Management theory From monopoly supplier to mixed sourcing based on functions that can add value versus activities where the main contribution is cost savings

Currie (2003) Procuring IT services from a vendor in a long-term relationship

Knowledge management theory

Risks at loosely coupled links between many different vendors

Earl (1996) Subcontract IT functions Economic theory Cost cutting Elitzur and Wensley (1998) Transfer of assets and

services between company and vendor

Game theory Principal-agent games payoff

Grover, Cheon, and Teng (1996)

Turning over part or all of an organization’s IS functions to external service provider(s)

Resource dependence theory, transaction cost theory

Service quality and partnership

Grover, Teng, and Cheon (1998)

Turning over IS functions to external service provider(s)

Strategic decision making, economic theory

External services like applications development and maintenance, systems operations, networks and telecom management

Hindle, Willcocks, Feeny, and Lacity (2003)

Externalization of people, systems, and institutional knowledge

Governance theory Vital intellectual capital often leaves the organization when key processes are outsourced

Hirschheim and Lacity (2000) Transferring IT assets, leases, staff, and management responsibility to third-party vendors

Decision-making theory Companies most likely outsource on a large scale when they are in poor financial conditions, have poor IT functions, or have IT functions with little status within the organization

Ho, Ang, and Straub (2003) Spin-off of IT functions Agency theory Persistent managerial



Ho, Ang, and Straub (2003) Spin-off of IT functions Agency theory Persistent managerial expectations after outsourcing

Hu, Saunders, and Gebelt (1997)

Contract out all or part of its IS operations

Decision-making theory Combined effects of external media, vendor pressure, and internal communications at the personal level among managers

Kern and Willcocks (2002) Contract out or sell to a third- party supplier

Interaction theory The elements of the interaction approach (services, information, financial, social), the parties involved, the environment, the atmosphere

Kern, Willcocks, and Heck (2002)

Contract out or sell to a third-party supplier

Winner’s curse theory Suppliers take a risk in hoping that they can recover their costs

Lacity and Willcocks (1998) Transformation of traditional IT departments

Management theory Indicators of success and failure

Lacity and Willcocks (2000b) Transfer to suppliers Relational theory Relationship stakeholders, relationship types, relationship phases and related activities

Lacity, Willcocks, and Feeny (1996)

Dismantle internal IT departments by transferring to third-party vendors

Economic theory Critical factors such as degree of technological maturity and degree of technology integration

Langfield-Smith and Smith (2003)

Contracting of any service or activity to a third party

Transaction cost theory, agency theory

Characteristics of the transaction, transaction environment and parties

Leiblein (2003) Organizational governance form

Transaction cost theory, resource-based theory, real options theory

Resource heterogeneity, role of uncertainty, direction for integration

Leiblein, Reuer, and Dalsace (2002)

Organizational governance form

Transaction cost theory Technological performance

Levina and Ross (2003) Transfer property and decision rights to an external organization

Client–vendor relationship Vendor efficiency is based on complementarities in organizational design, core competencies, and relationship management structures

Linder (2004) Partnering with another company

Organizational change Four varieties are rapid start-up, pathway to growth, change catalyst, and radical renewal

Loh and Venkatraman (1992a)

Contribution by external vendors

Neoclassical economics, procurement activities

Business and IT cost structures, IT performance

Lorence and Spink (2004) Vendors helping companies integrate networks and solve information access

Decision-making theory Functions most likely to be outsourced

Sambamurthy and Zmud (2000)

Design of effective IT organizational architecture

Theories of organizing logic Identify critical IT capabilities, design relational architectures for capabilities, design integration architectures

Steensma and Corley (2001) IT function outside firm boundary

Theories of firm boundaries Transaction cost, commercial failure, sustainable advantage, organizational context

Willcocks and Lacity (1999) Management of IT capabilities

Decision-making theory Risk, creative contracting, and business advantage

Table 2.3. Outsourcing definitions in the research literature, cont.

IT Outsourcing 23


and the authors pay attention to how to deal with uncertainty and risk encompassed inoutsourcing. Where Barthélemy is concerned with management expertise as a predictorof success or failure, Langfield-Smith and Smith are concerned with the design ofmanagement control systems.Outsourcing is a phenomenon in which a user organization (client) transfers propertyor decision rights over information technology infrastructure to an external (vendor)organization (Levina & Ross, 2003). By using this definition, Levina and Ross direct theirresearch at how vendors can deliver financial and managerial benefits to their clients thatoutweigh contracting costs and risks. But instead of using traditional economic theories,they apply the concept of complementarity in organizational design as well as the corecompetency argument in outsourcing and theories of client–vendor relationships. Theyexplain variability in outsourcing outcomes by using relationship factors as predictors.In Table 2.3, some of the definitions used in the research literature on IT outsourcing islisted. We find that many of the researchers did not define outsourcing. Among thosewho did, we have seen that definitions vary, both according to outsourcing perspectiveand according to theoretical perspective. In Chapter IV we will go further in thediscussion of theoretical perspectives on IT outsourcing.The term “outsourcing” can be studied further by using the opposite term “insourcing.”Hirschheim and Lacity (2000) define insourcing as the practice of evaluating theoutsourcing option, but confirming the continued use of internal IT resources to achievethe same objectives of outsourcing. They studied six decision factors: decision scope,decision sponsor, evaluation process, year of decision, size of the organization, anddecision outcome. Lacity et al. (1996) define total insourcing as the management andprovision of at least 80% of the IT budget internally after evaluating the IT service market.The common element of the two definitions seems to be that customers evaluate theexternal IT services market before a sourcing decision takes place.An outsourcing relationship consists of a vendor (supplier) and a client (customer). Thevendor is a firm that has the technology. This firm is sometimes called the source firm(Steensma & Coorly, 2001) and sometimes called the outsourcer (Beamount & Costa,2002). The client is a firm that desires the technology. This firm is sometimes called thesourcing firm and sometimes called the outsourcee. For the purpose of clarity, Table 2.4lists some of the key terms used in this book.

Figure 2.4. Definitions of some key terms for later use

Key term Definition Insourcing The practice of evaluating the outsourcing option, but confirming the continued use of internal IT

resources to achieve the same objectives of outsourcing. Offshoring The practice of migrating business process overseas to lower costs without significantly sacrificing

quality. This practice is also called global outsourcing. Outsourcing A process whereby an organization decides to contract out or sell the firm’s IT assets, people,

and/or activities to a third-party supplier, who in exchange provides and manages these assets and services for an agreed fee over an agreed time period.

Selective sourcing Selected IT functions are located with external providers while still providing between 20–80% of IT budget.

Source firm The firm that has the technology. The source firm is sometimes called vendor, supplier, or outsourcer.

Sourcing firm The firm that desires the technology. The sourcing firm is sometimes called client, customer, or outsourcee.

Transformational outsourcing

Partnering with another company to achieve a rapid, substantial, and sustainable improvement in enterprise-level performance.



Business Example: Offshore InsuranceBusiness Process Outsourcing

Insurance companies have the value configuration of a value network. They connectpeople who are afraid of risk to people who have been hit by a risk. People who are afraidof damage to their car, house, or health pay a premium to the insurance company. Peoplewho have damage to their car, house, or health receive a payment from the insurancecompany. The insurance company creates an arena for risk sharing by receiving andtransferring premium money to those who experience damage to their insured objects.There has been a rise of offshore BPO for mission-critical insurance operations, such aspolicy administration and claims processing. From a theoretical perspective, offshoreBPO sounds promising. Savings can be found from moving staffing and operations todeveloping regions, such as India, China, South Africa, or the Philippines. These regionsmay provide the availability of human resources who may run insurance processing ata lower cost than can be done internally or with onshore BPO providers. However, dothe savings justify the risks involved with moving operations overseas, such as politicalbacklash, instability of the region, or loss of process control? Additionally, will the costsavings be a short-lived benefit as conditions improve in the region or as migration andprocess management costs rise?Insurers, already burdened with legacy systems, large books of business that may bedwindling over time, and industry pressures to reduce operational costs, will find the costsavings attractive. Two out of three primary activities in an insurance company seemattractive for outsourcing: customer services and operational infrastructure. Insurersthat have past experience with IT outsourcing or third-party administrators may feelconfident about leveraging their sourcing experience to enter offshore BPO in areas suchas customer requests, claims, or policy administration processes, which all belong to theprimary activity of customer services.However, initiating and managing offshore BPO is a challenge for insurance companies.Fears regarding offshore BPO for insurance processes center around several issues:

• The inability to position offshore BPO providers in direct interaction with businessmanagers.

• Concern over the loss of customer interaction for servicing activities, as insurersmust control and closely manage customer interaction.

• Systems and data availability, because mission-critical processes and data cannothave downtime or periods in which systems are not available to users.

• Lack of Web-enables systems that would enable external accessibility.• Compliance with privacy regulations and how to enforce privacy breaches outside

of the country of operations.• Inability to manage the process when one part of the complex process is done

externally.

IT Outsourcing 25


These challenges may deter insurers from engagement in large-scale BPO, except forisolated activities or diminishing processes, such as closed book-of-business process-ing (Gartner, 2004a).

Business Example: Ministry ofChildren and Family Affairs

Statens barnevern og familievern (SBF, http://www.sbf.stat.no) is the Norwegian gov-ernmental office for the welfare and protection of children and families. Its main objectiveis to provide services of high and accurate quality to children, young people, and familiesin need of assistance and support regardless of where in Norway they live. The activitiesof SBF encompass assistance to the municipalities in child welfare cases, the running ofinstitutions for children, foster home services, family-based measures, family carecenters, and initial handling of applications for adoption. SBF is organized in five regionsunder a central leadership directly linked to the Ministry of Children and Family Affairs.SBF has taken over the activities that were previously handled by the County Councilsin Norway.SBF is a new department in the government, and needed to quickly get its IT infrastructureup and running. The IT functions’ role is mainly to facilitate accessibility and function-ality for their users in offices throughout Norway. The solution is based on Microsoft2003 software and Citrix technology in a centralized operations center. The IT infrastruc-ture is designed and implemented by Ementor, which had the full responsibility ofbuilding and running the IT systems in a temporary phase of three months. In additionto the outsourcing business, Ementor helps SBF with consultancy service, IT strategy,organization, project management, acquisition, implementation, and testing. Ementorhas also conducted many other projects such as IT security consultancy, organizationalrestructuring assistance, enterprise resource planning (ERP) implementation, and ITstrategy preparation.When selecting a partner for this vital project, SBF emphasized experience, proven abilityto execute projects of this size, and prepare for skills transfer and operations of thesolution. Ementor was chosen on the basis of the totality in the offer. Ementor is excitedto be a partner in building the ICT infrastructure for the new governmental office. “Wehave thorough experience in comparable large solutions with strict security regulations,”says Vice President Steinar Sønsteby. The operations solution at SBF consists of projectmanagement, test management, consultancy, service desk, firewall and LAN/WANmanagement, technical service, and on-site operations.



Case Study: Total OutsourcingKeeping a Strong In-House Group

Rolls-Royce is a global power systems company providing power for land, sea, and air,with leading positions in civil aerospace, defense, marine, and energy markets. Rolls-Royce is also one of the most famous names in engineering throughout the world.The history of Rolls-Royce began in 1884, when Henry Royce and Charles Rolls startedto build, manufacture, and sell quality cars. Success with the cars led to the formationof the Rolls-Royce Company in March 1906 and the launch of the six-cylinder SilverGhost, which within a year, was hailed as “the best car in the world.” At the start of WorldWar I, Royce designed his first aero engine, used in the air war by the allies. Demand forthe Merlin engine, which powered the Spitfire, during World War II transformed Rolls-Royce from a relatively small company into a major contender in aeropropulsion. Rolls-Royce entered the civil aviation market in 1953, and the company has become a majorplayer in this market. In the 1980s and 1990s, Rolls-Royce underwent a number of mergersand acquisitions to create the only company in Britain capable of delivering power foruse in air, at sea, and on land. There are now some 54,000 Rolls-Royce gas turbines inservice and these generate a demand for high-value service throughout their operationallive. Today, Rolls-Royce is a technology leader, employing 35,200 employees andoperating in 48 countries. Group turnover in 2003 ended at £5,645 million (Rolls-Royce,2004a, 2004b).Until 1996 Rolls-Royce had its own IT operation. The company was growing rapidly inthe 1990s, and both IT costs and the number of IT employees were increasing dramati-cally. In the IT business, there was a change between large mainframes and green screensto graphic user interface (GUI) and clustered server environments. The company reacheda point where it had to manage both environments. The then CIO conducted a study ofthe capability of the IT function. He had serious doubts about the in-house teams’ abilityto handle the change, in terms of both capability and scale. In addition, Rolls-Royce wasfinancially strapped. It considered outsourcing as one way, at least in the short term, tohelp the company deliver its results. Rolls-Royce also needed a change agent. So, thecompany began to look outside for a partner to deal with those aspects. Today, Rolls-Royce has around 30,000 computers users, and many of the staff are using ERP systems.The first outsourcing deal was done in 1996, and was renewed in 2000 for 12 more years.Rolls-Royce outsourced the basic operation of the complete infrastructure—the man-agement of networks, data centers, servers, and so on. And it outsourced the applicationsupport for most of its major applications and the application development function.What was kept was development of internal software at the control level, such as controlsystems for jet engines. All major assets were transferred, such as computers, software,and people. More than 1,200 people were transferred from Rolls-Royce to EDS. Sincealmost 90% of the IT budget goes with the outsourcer, we may regard this as a totaloutsourcing. Total outsourcing transfers IT assets, leases, staff, and managementresponsibility for delivery of IT services from internal IT function to a third-party vendor,and which represents at least 80% of the IT budget (Lacity et al., 1996). The intention wasto put a long-term agreement in place, and to build a close relationship.

IT Outsourcing 27


In the early years, after the initial outsourcing, Rolls-Royce kept very little competencein-house. But it realized that that was unhelpful, because keeping little competence in-house created naïveté on the company’s side and a degree of frustration on theoutsourcer’s side. This was later corrected and now it has senior people with experienceof managing outsourcers. The central staff doing IT cover the architecture, oversight ofprojects, and management of service levels.In 1999, when Rolls-Royce acquired Vickers (now Rolls-Royce Commercial Marine), thecompany obtained a strong in-house IT group with more than 70 professionals. Thisgroup provided operational IT services for more 3,200 people at 50 locations worldwide.A memorandum of understanding was signed in 2000 between Rolls-Royce and EDS toevaluate outsourcing of this group. The process was stopped, concluding thatoutsourcing was not profitable for Rolls-Royce. The in-house IT group of Rolls-RoyceCommercial Marine is a self-efficient group with very significant geographic boundaries,located in Norway, and serving small business units primarily in Norway, Sweden, andFinland. It has just over 10% of the overall IT budget. IT is kept in-house of two reasons.First of all, it is not in the natural environment for an outsourcer. And second, maintaininga complete vertical capability in IT is healthy from the CIO’s perspective. It is possibleto build on that group to bring services back in-house, and it provides Rolls-Royce withdirect cost comparison versus the outsourcer.



Chapter III

Some FundamentalPerspectives

In this chapter, we cover some topics that contribute to a broader understanding of therole of IT outsourcing. We start by presenting value configurations consisting of primaryand secondary activities in order to understand the role of IS/IT in different valueconfigurations such as value chains, value shops, and value networks. Next, we look atelectronic business infrastructure, where the extent of IT outsourcing can be determinedby choosing from a list of 70 infrastructure services. E-business has a double role here,as an outsourced IT function more and more will be handled electronically. This meansthat the transactions between vendor and client after outsourcing will be conducted aselectronic business. Third, we present a vendor value proposition that explains why avendor may create value for the client because of its complementary competencies. Then,we look at IT function organization, outsourcing performance, and successful relation-ships. We conclude this chapter by discussing opportunities and threats in IT outsourcing.

Value Configurations

To comprehend the value that information technology provides to organizations, wemust first understand the way a particular organization conducts business and how ISaffect the performance of various component activities within the organization. Under-standing how firms differ is a central challenge for both theory and practice of manage-ment, and such understanding is critical to ensure that the value of IT is recognized,exploited, and expanded in IT outsourcing.For a long time, Porter’s (1985) value chain was the only value configuration known tomanagers. Stabell and Fjeldstad (1998) have identified two alternative value configura-

Some Fundamental Perspectives 29


tions. A value shop schedules activities and applies resources in a fashion that isdimensioned and appropriate to the needs of the client’s problem, while a value chainperforms a fixed set of activities that enables it to produce a standard product in largenumbers. Examples of value shops are professional service firms, as found in medicine,law, architecture, and engineering. A value network links clients or customers who areor wish to be interdependent. Examples of value networks are telephone companies, retailbanks, and insurance companies.A value configuration describes how value is created in a company for its customers. Avalue configuration shows how the most important business processes function tocreate value for customers. A value configuration represents the way a particularorganization conducts business.

Value Chain

The best-known value configuration is the value chain. In the value chain, value iscreated through efficient production of goods and services based on a variety ofresources. The company is perceived as a series or chain of activities. Primary activitiesin the value chain include inbound logistics, production, outbound logistics, marketingand sales, and service. Support activities include infrastructure, human resources,technology development, and procurement. Attention is on performing these activitiesin the chain in efficient and effective ways. In Figure 3.1, examples of IS/IT are assignedto primary and support activities. This figure can be used to describe the current IS/ITsituation in the organization as it illustrates the extent of coverage of IS/IT for eachactivity.To deliver low-cost or differentiated products, a firm must perform a series of activities.The different activities are called the firm’s value chain. The typical assembler/manufacturer’s value chain can be illustrated using the example of a manufacturer ofcomputer hardware, such as a personal computer. The inbound logistics stage involvesraw materials handling, such as computer central processing unit (CPU) chips, memorymodules, disk drives, fans, and so forth. A manager would also have to worry about aninspection of the materials, selection of parts, and delivery issues. The production stageinvolves the production of in-house components, assembly of the computer, testing andtuning, maintenance of equipment, and operation of the plant. The outbound logisticsstage involves order processing and shipping. The marketing and sales stage isconcerned with advertising, pricing, promotion, and management of the sales force.Finally, the service stage involves managing technical support and service representa-tives and replacement and repair of computers. In performing the activities of its valuechain, a firm must interact with suppliers, customers, and firms in related industries. Theother firms also have value chains of their own. A system of value chains is called a valuechain system (Afuah & Tucci, 2003).The value chain is more about efficiency than about new product development. It is aboutprocess more than product. And it is about low cost more than differentiation. The valuechain describes the necessary activities once a product and its features have beenconceived, and it is not necessarily concerned with developing a continual stream ofinnovations. However, marketing does have two roles in the value chain. The first was



implied above: to stimulate demand for the product. The second role, however, is toprovide input into the product specifications themselves, along with estimates ofexpected volume. This allows for limited differentiation.

Value Shop

Value cannot only be created in value chains. Value can also be created in two alternativevalue configurations: value shop and value network (Stabell & Fjeldstad, 1998). In thevalue shop, activities are scheduled and resources are applied in a fashion that isdimensioned and appropriate to the needs of the client’s problem, while a value chainperforms a fixed set of activities that enables it to produce a standard product in largenumbers. The value shop is a company that creates value by solving unique problemsfor customers and clients. Knowledge is the most important resource, and reputation iscritical to firm success.While typical examples of value chains are manufacturing industries such as paper andcar production, typical examples of value shops are law firms and hospitals. Often, suchcompanies are called professional service firms or knowledge-intensive service firms.Like the hospital as a way to practice medicine, the law firm provides a standard formatfor delivering complex legal services. Many features of its style—specialization, team-work, continuous monitoring on behalf of clients (patients), and representation in manyforums—have been emulated in other vehicles for delivering professional services(Galanter & Palay, 1991).Knowledge-intensive service firms are typical value shops. Sheehan (2002) definesknowledge-intensive service firms as entities that sell problem-solving services, wherethe solution chosen by the expert is based on real-time feedback from the client. Clientsretain knowledge-intensive service firms to reduce their uncertainty. Clients hire knowl-edge-intensive service firms precisely because the client believes the firm knowssomething that the client does not and believes it is necessary to solve its problems.While expertise plays a role in all firms, its role is distinctive in knowledge-intensive

Figure 3.1. Examples of IS/IT in the value chain

Infrastructure: Use of corporate intranet for internal communications Human resources: Use of corporate intranet for competence building Technology: Computer-aided design (CAD) Procurement: Use of electronic marketplaces Inbound Production: Outbound Marketing Service: logistics: Computer logistics: and sales: System Electronic Integrated Web-based Customer for Data Manufacturing order- Relationship local Interchange (CIM) tracking Management troubleshooting (EDI) system (CRM)



service firms. Expert, often professional, knowledge is at the core of the service providedby the type of firm.Knowledge-intensive service firms not only sell a problem-solving service, but also aproblem-finding, problem-defining, solution-execution, and monitoring service. Problemfinding is often a key for acquiring new clients. Once the client is acquired and its problemis defined, not all problems will be solved by the firm. Rather the firm may only clarify thatthere is no problem (e.g., the patient does not have a heart condition) or that the problemshould be referred to another specialist (e.g., the patient needs a heart specialist). If aproblem is treated within the firm, then the firm needs to follow up the implementationto assure that the problem in fact has been solved (e.g., is the patient’s heart now workingproperly?). This follows from the fact that there is often uncertainty in both problemdiagnosis and problem resolution.Sheehan (2002) has created a typology of knowledge-intensive service firms consistingof the following three types. First, knowledge-intensive firms search for opportunities.The amount of value they create depends on the size of the finding or discovery, wheresize is measured by quality rather than quantity. Examples of search firms includepetroleum and mineral exploration, drug discovery in the pharmaceutical industry, andresearch in the biotechnology industry. Second, knowledge-intensive diagnosis firmscreate value by clarifying problems. Once the problem has been identified, the suggestedremedy usually follows directly. Examples of diagnosis firms include doctors, surgeons,psychotherapists, veterinarians, lawyers, auditors and tax accountants, and softwaresupport. Finally, knowledge-intensive design firms create value by conceiving new waysof constructing material or immaterial artifacts. Examples of design firms include archi-tecture, advertising, research and development, engineering design, and strategyconsulting.Knowledge-intensive service firms create value through problem acquisition and defi-nition, alternative generation and selection, implementation of an alternative, and followup to see if the solution selected resolves the problem. To reflect this process, Stabelland Fjeldstad (1998) have outlined the value configuration of a value shop. A value shopis characterized by five primary activities: problem finding and acquisition, problemsolving, choice, execution, and control and evaluation, as illustrated in Figure 3.2.Problem finding and acquisition involves working with the customer to determine theexact nature of the problem or need. It involves deciding on the overall plan ofapproaching the problem. Problem solving is the actual generation of ideas and action(or treatment) plans.Choice represents the decision of choosing between alternatives. While the leastimportant primary activity of the value shop in terms of time and effort, it is also the mostimportant in terms of customer value. Execution represents communicating, organizing,and implementing the decision, or performing the treatment. Control and evaluationactivities involve monitoring and measurement of how well the solution solved theoriginal problem or met the original need.This may feed back into the first activity, problem finding and acquisition, for tworeasons. First, if the proposed solution is inadequate or did not work, it feeds back intolearning why it was inadequate and begins the problem-solving phase anew. Second, ifthe problem solution was successful, the firm might enlarge the scope of the problem-



solving process to solve a bigger problem related to or dependent upon the first problembeing solved (Afuah & Tucci, 2003).Knowledge-intensive service firms are typical value shops, and such firms depend onreputation for success, as reputation is a key driver of firm value creation. Reputation isa relational concept, in the sense that firms are judged by their stakeholders relative totheir competitors. Reputation is what is generally said or believed about an entity bysomeone, it is the net perception of a firm held by stakeholders judged relative to otherfirms. According to Sheehan (2002), there are four conditions that must be present forreputation to work. First, rents earned from maintaining a good reputation must be greaterthan not. Second, there must be a minimum of contact among stakeholders to allow forthe changes in reputation to be communicated. Third, there needs to be a possibility ofrepeat business. And last, there must be some uncertainty regarding the firm’s type and/or behavior.Reputation is related to the asymmetry of information, which is a typical feature ofknowledge-intensive service firms. Asymmetry is present when clients believe the firmknows something that the clients do not and believe it is necessary to know to solve theirproblems. Reputation can be classified as a strategic resource in knowledge-intensivefirms. To be a strategic resource, it has to be valuable, rare, and costly to imitate, andpossible to organize. Reputation is valuable as it increases the value received by theclient. Reputation is rare, as by definition only a few firms can be considered best in theindustry. Reputation is costly to imitate, as it is difficult to build a reputation in the shortrun. Reputation is possible to organize in the general sense of controllability, whichimplies that a firm can be organized to take advantage of reputation as a resource.

Figure 3.2. Examples of IS/IT in the value shop

Infrastructure: Use of corporate intranet for internal communications

Human resources: Use of corporate intranet for competence building

Technology: Image processing

Procurement: Use of electronic marketplaces

Problem finding and acquisition: Client database

Execution of solution: Document system

Control and evaluation:

Accounting system

Choice of solution to problem:

Simulation system

Problem solving: Best-practice database



Value Network

The third and final value configuration is the value network. A value network is acompany that creates value by connecting clients and customers that are, or want to be,dependent on each other. These companies distribute information, money, products, andservices. While activities in both value chains and value shops are done sequentially,activities in value networks occur in parallel. The number and combination of customersand access points in the network are important value drivers in the value network. Morecustomers and more connections create higher value to customers.Stabell and Fjeldstad (1998) suggest that managing a value network can be compared tomanaging a club. The mediating firm admits members that complement each other, andin some cases exclude those that do not. The firm establishes, monitors, and terminatesdirect or indirect relationships among members. Supplier-customer relationships mayexist between the members of the club, but to the mediating firm they are all customers.Examples of value networks include telecommunication companies, postal services,financial institutions such as banks and insurance companies, and stockbrokers. Asillustrated in Figure 3.3, value networks perform three activities:

• Development of customer network through marketing and recruiting of newcustomers, to enable increased value for both existing customers and newcustomers. This activity involves promoting and building the network, acquiringcustomers, and managing contracts for service provision. The management ofcontracts involves the initiation, maintenance, and termination of contracts to

Figure 3.3. Examples of IS/IT in the value network

Infrastructure: Use of corporate intranet for internal communications

Human resources: use of corporate intranet for competence building

Technology: Network efficiency monitoring system

Procurement: Use of electronic marketplaces

Customer Network Customer Relationship Management (CRM) Customer Services

Value-Added Services System

Operational Infrastructure Security System



provide whatever service the intermediary proposes to furnish. This activity isdistinguished from sales and marketing in the value chain by its active selectionof customers to join the network. As the level of commitment rises, the complexityof the contracting process and of the contracts themselves rises.

• Development of new services and improvement in existing services. Serviceprovisioning involves linking people in the network and then collecting paymentfrom them for making the connection. Specifically, it involves setting up con-tracts—directly, as in real-time chat telephone service, or indirectly, as in bankingor e-mail—seeing that the contacts are maintained for the appropriate amount oftime, and ending the contact at the appropriate moment. Collecting payment isabout tracking the usage (both volume and time) and billing for direct contact or,in the case of indirect contacts, collecting a commission for putting the two partiestogether. Upon receiving a service request, the intermediary needs to check thefeasibility of making the connection as well as the eligibility of the requestor.

• Development of infrastructure so that customer services can be provided moreefficiently and effectively. Infrastructure operations are activities that allow theinfrastructure to operate efficiently and remain in a state of readiness to provideservice to the next customer. Stabell and Fjeldstad (1998) provide examples ofdifferent types of infrastructure activities that vary with the type of network: Fortelecommunications providers, the main infrastructure is embedded in switchesand distribution centers; for postal services, it is collecting, sorting, and deliveryof mail and package services; for financial services companies, it is embedded inthe branch offices, financial assets, or connections to trading floors.

The value network is an extensive connector, a machine for establishing connections andproviding services to support the exchanges customers want to make across them. Themanagerial trade-off is between reach (network size) and richness (capacity and services)between whom you can connect and what you can do for them. Large network sizeincreases connectivity measured in nodes (frequently customers) that can be reached.Capacity increases speed of change. The major costs are associated with attractingcustomers to increase the value of membership and building the infrastructure andservices to carry customer exchanges. Costs are predominantly fixed (Fjeldstad &Andersen, 2003).The current IS/IT situation in a value network will mainly be described through theinfrastructure that will typically consist of IT. In addition, many of the new services maybe IS that will be used by customers in their communication and business transactionswith other customers. The knowledge component will be mainly found in the services ofa value network, as IS are made available to customers to exchange relevant information.According to Andersen and Fjeldstad (2003), the mediating technology is extensive. Itis used to connect customers that are or wish to be interdependent. The quality ofmediation services depends on the nodes between which exchange can take place andon what type of objects can be exchanged. Therefore, nodes and links covered by theservice are primary resources of mediators. Control of nodes and links enable mediatorsto perform activities that convey the objects of interest. Service quality depends onproperties of the links between the nodes. Links properties, for example, bandwidth or



security, determine what objects can be exchanged as well as the speed, capacity,reliability, and security exchanges. Higher-level specialization services, for example,exchange of payment transactions, depend on use of general lower-level services as amedium. The mediation networks made available by these lower-level services arenecessary resources in the provisioning of higher-level services. Conversely, the higher-level mediation networks are also resources for the lower-level networks; they provideuses of the latter.

The Role of IT in Different Value Configurations

The strategic impact of technology and IT are different in the three value configurations.While the value chain has cost orientation, the value shop is oriented toward value, andthe value network needs to balance cost and value, as scale and capacity utilization aredrivers of both. Andersen and Fjeldstad (2003) suggest that much use of IT today iscounterproductive, because of a lack of understanding of the underlying business logicin different value configurations. In particular, they suggest that companies andorganizations in the network and shop configuration have implemented IT to pursueeconomic goals derived from a model of the company or organization as a chain. It isimportant to be aware of the different value configurations when developing andimplementing new IT.Value chain, value shop, and value network are alternative value configurations thatimpact the use of IT in the company as illustrated in Table 3.1. While the role of IT is tomake production more efficient in a value chain, IT creates added value in the value shop,while IT in the form of infrastructure is the main value in the value network. Somecompanies have more than one value configuration, but most companies have onedominant configuration.

Table 3.1. Characteristics of the three value configurations

Chain Shop Network Value creation logic

Transformation of input into output

Solving customer problems

Linking customers

Primary technology Long-linked Intensive Mediating Work characteristic

Sequential production Integrated and cyclical problem solving

Monitored and simultaneous connections

Primary activities Inbound logistics, operations, outbound logistics, marketing, service

Problem finding, problem solving, choice, execution, control/evaluation

Network promotion, service provisioning, infrastructure operation

Role of IT Improve product and process

Coperformed with primary activities

Part of basic infrastructure

Contribution from IS

Making production more efficient and effective

Adding value to knowledge work

Adding value to infrastructure services

Examples Pulp and paper industry, car manufacturing, and IT hardware industry

Law firms, hospitals, consulting, police, and government authorities

Telecom industry, postal services, banking, finance, and insurance



In the long term, business organizations can choose to change their value configura-tions. A bank, for example, can be a value shop when it focuses on converting inputs tooutputs. The value resides in the output, and once you have the output, you can removethe production organization. This removal does not impact the value of the output. Thevalue shop is a solution provider. It is somebody who solves problems. The input is aproblem. The output is a solution to the problem. A bank that does this would view itselfas a financial service operator, a financial adviser that also has the ability to provide themoney. But what it would do is identify client problems, address those problems, selecta solution together with the client, and help to implement it. It would have stringentquality controls. As part of its offering, it would probably supply the client with somecash as a loan or accept some of the client’s cash for investment. Or the bank can be avalue network, which is basically the logic of the marketplace. The bank would define itsrole as a conduit between people who do not have money and those who do have money.What the bank does is to arrange the flow of cash between them. The bank will attractpeople with money to make deposits and investments. The bank will also attract peoplewithout money to make loans. As a value network, the bank will connect people withopposite financial needs. The network consists of people with different financial needs.Over time, people in the network may change status from money needer to moneyprovider and vice versa (Chatzkel, 2002).Both as a value shop and as a value network, the business organization can be identifiedas a bank. However, it would have completely different consequences for what it willfocus on doing well, what it will focus on doing itself, versus what it would not want todo itself. This provides a kind of strategic systems logic. It asks, “Which strategic systemin terms of value configuration are we going to operate in?” Choosing an appropriatevalue configuration is a long-term decision with long-term consequences.

Interfirm Relations in Value Systems

To be able to identify potential areas for outsourcing in the firm, it is important tounderstand firm boundaries and firm relations. Interfirm relations and institutionalarrangements that parties deploy to support exchange exist within the context of valuesystems. A value system consists of all the activities and firms that create and delivervalue to the end customer (Andersen & Fjeldstad, 2003).From our outsourcing perspective, interfirm relations are a challenge, as they may notbe obvious who is the outsourcer; is it firm A or firm B, or both, as illustrated in Figure3.4? Firm A uses the operational infrastructure of firm B to provide customer services.For example, a telecom firm may use the physical infrastructure such as antennas of acompeting telecom firm to provide its services, so that a forest of antennas fromcompeting firms does not cover a country.A value system describes the division of labor among firms and defines exchangesrelevant for integration of end value. Value system properties are potentially importantdeterminants of interfirm relations because the organization of exchanges is likely todepend on the properties of the objects exchanged. For example, the exchange ofknowledge or skills is more likely to occur in networks, whereas the transfer of tangible



Figure 3.4. An example of interfirm relations in value networks







Firm A

Firm B

Figure 3.5. An example of outsourcing vendor as value shop and outsourcing client asvalue network

Customer Network Customer Relationship Management (CRM)

Customer Services Value Added Services System


Outsourcing client

Problem finding and acquisition: Client database

Execution of solution:

Document system

Control and evaluation:

Accounting system

Choice of solution

to problem: Simulation system

Problem solving: Best-practice

database

Outsourcing vendor



items more commonly occurs through a market transaction. Firms that perform similar orsubstitutable activities in a value system compete. Firms that perform complementingactivities in a value system may cooperate to maximize their joint value creation(Andersen & Fjeldstad, 2003).In our outsourcing context, the vendor and the client can be understood as a value systemas illustrated in Figure 3.5. In this example, the outsourcing vendor is defined as a valueshop that solves client problems. The outsourcing client might be a telecom firm that buysproblem-solving services from the vendor.

E-Business Infrastructure

To obtain a thorough understanding of outsourcing implications in terms of services thatthe vendor has to provide its customers, we will look at e-business infrastructure as anexample. Weill and Vitale (2002) identify a total of 70 infrastructure services that arerelevant for e-business. The actual number of infrastructure services needed by acompany depends on the company’s e-business model. Some e-business models requiremany services, while others require few. For a company to provide a total of 70infrastructure services in case they are all needed may be difficult and too costly. For avendor, providing all 70 infrastructure services may be feasible, as clients will draw ondifferent infrastructure services as they may apply to different e-business models.

E-Business Models

Weill and Vitale (2001) define an e-business model as a description of the roles andrelationships among a firm’s consumers, customers, allies, and suppliers that identifiesthe major flows of product, information, and money, and the major benefits to partici-pants. There are many different ways to describe and classify e-business models. Thereis a finite number of atomic e-business models; each captures a different way to conducte-business. Firms can combine atomic e-business models as building blocks to createtailored e-business models and initiatives, using their competencies as their guide. Theyidentified a small number of eight atomic e-business models, each of which describes theessence of conducting business electronically.

Direct to Customer

The distinguishing characteristic of this model is that buyer and seller communicatedirectly, rather than through an intermediary. The seller may be a retailer, a wholesaler,or a manufacturer. The customer may be an individual or a business. Examples of thedirect-to-customer model are Dell Computer Corporation (www.dell.com) and Gap, Inc.(www.gap.com).Infrastructure. The direct-to-customer model requires extensive electronic connectionwith the customer, including online payment systems. Many direct-to-customer imple-



mentations include an extranet to allow customized Web pages for major business-to-business (B2B) customers. Operating a direct-to-customer e-business requires signifi-cant investment in the equivalent of the store: the Web site. Direct-to-customerbusinesses spend millions of dollars developing easy-to-navigate and easy-to-use Websites with the goal of improving the B2B or business-to-consumer (B2C) shoppingexperience online. For example, Lands End (www.landsend.com) has devised a featureby which women can build and store a three-dimensional model of themselves to “try on”clothes electronically.In their field research, Weill and Vitale (2001) find that firms with e-business initiativescontaining the direct-to-customer e-business model need and are investing more heavilyin three areas of infrastructure services: application infrastructure, communications, andIT management.Direct-to-customer firms particularly need payment transaction processing to processonline customer payments, enterprise-wide resource planning (ERP) to process customertransactions, work flow infrastructure to optimize business process performance, com-munication network services linking all points in the enterprise to each other and theoutside world (often using TCP/IP protocol), the installation and maintenance ofworkstations and local area networks supporting the large number of people required tooperate a direct-to-customer model, and service-level agreements between the businessand the IT group or outsourcer to ensure, monitor, and improve the systems necessaryfor the model.Sources of Revenue. The main source of revenue in the direct-to-customer model isusually direct sales to customers. Supplemental revenues come from advertising, the saleof customer information, and product placement fees.Critical Success Factors. Critical success factors are the things a firm must do well toflourish. The following list shows the critical success factors for the direct-to-customermodel: create and maintain customer awareness in order to build a critical mass of usersto cover the fixed cost of building an electronic presence; reduce customer acquisitioncosts; strive to own the customer relationship and understand individual customerneeds; increase repeat purchases and average transaction size; provide fast and efficienttransaction processing, fulfillment, and payment; ensure adequate security for theorganization and its customers; and provide interfaces that combine ease of use withrichness of experience, integrating multiple channels.

Full-Service Provider

A firm using the full-service provider model provides total coverage of customer needsin a particular domain, consolidated via a single point of contact. The domain could beany major area of customer needs requiring multiple products and services, for example,financial services, health care, or industrial chemicals. The full-service provider addsvalue by providing a full range of products, sourced both internally and externally, andconsolidating them using the channel chosen by the customer. Examples of the full-service provider are the Prudential Advisor (www.prusec.com) and GE Supply Company(www.gesupply.com).



Infrastructure. Virtually all businesses aspire to obtaining 100% of their customers’business, or at least to getting as much of that business as they can handle profitably.Yet the number of full-service providers remains small. Part of the reason for this is therequired infrastructure. The missing piece of infrastructure in many businesses is oftena database containing information about the customer and the products that thecustomer owns. Without owning these data, a provider does not own the customerrelationship, and therefore some of the customer’s transactions are likely to take placedirectly with other providers. All of the important interactions with customers occurringacross any channel or business unit must be recorded in the firm-wide customer database.Weill and Vitale (2001) identify in their field research databases and data warehouses assome of the most important infrastructure services associated with the full-serviceprovider model. Other important infrastructure services include the following: the abilityto evaluate proposals for new IS initiatives to coordinate IT investments across amultibusiness-unit firm with the goal of a single point of contact for the customer;centralized management of IT infrastructure capacity to integrate across multiple busi-ness units within the firm and third-party providers, the full-service provider model is notreadily workable if each business unit optimizes its own IT needs; installation andmaintenance of workstations and local area networks to operate the online businesslinking all the business units and third-party providers; electronic support for groups tocoordinate the cross-functional teams required to implement this model; and the iden-tification and testing of new technologies to find cost-effective ways to deliver thiscomplex business model to the customer across multiple channels.Sources of Revenue. A full-service provider gains revenues from selling its own productsand those of others, and possibly also from annual membership fees, management fees,transaction fees, commissions on third-party products, advertising or listing fees fromthird-party providers, and fees for selling aggregated data about customers.Critical Success Factors. One important critical success factor is the brand, credibility,and trust necessary for a customer to look to the firm for its complete needs in an area.Another is owning the customer relationship in one domain and integrating andconsolidating the offering of many third parties into a single channel or multiplechannels. A third factor owns more of the customer data in the relevant domain than anyother player. A final factor is enforcement of policies to protect the interests of internaland external suppliers as well as customers.

Whole of Enterprise

The single point of contact for the e-business customer is the essence of the whole-of-enterprise atomic business model. Although many of this model’s breakthrough inno-vations have occurred in public-sector organizations, the model is applicable in both thefor-profit and public sectors. An example of this model is the Australian state of Victoriawith its Business Channel (www.business.channel.vic.gov.au) and Health Channel(www.betterhealth.vic.gov.au).Infrastructure. For the whole-of-enterprise model, infrastructure needs to link thedifferent systems in the various business units and provide a firm-wide perspective for



management. The field research by Weill and Vitale (2001) reveal that the followinginfrastructure services are the most important for implementing this model: centralizedmanagement of infrastructure capacity to facilitate integration and capture economies ofscale; identification and testing of new technologies to find new ways to integrate theoften different systems in many business units into a single point of customer contact;management of key data independent of applications and the creation of a centralizedrepository for firm-wide information; electronic means of summarizing data from differentapplications and platforms to manage the complexity arising from a single point of contactfor multiple business units; development of an ERP service to process the transactionsinstigated by customers interacting with several different business units, often requiringconsolidating or linking several ERPs in the firm; payment transaction processing, eitheron a firm-wide basis or by linking several systems across the business units; large-scaledata-processing facilities to process transactions from multiple business units, oftencentralized to achieve economies of scale; and integrated mobile computing applications,which provide another channel to the customer.Sources of Revenue. In the for-profit sector, revenues are generated by provision ofgoods and services to the customer by the business units. There may also be theopportunity to charge an annual service or membership fee for this level of service. Inthe government sector, the motivation is usually twofold: improved service and reducedcost. Service to the community is improved through continuous, round-the-clockoperation and faster service times. Sharing more infrastructures and eliminating the needto perform the same transaction in multiple agencies can potentially reduce governmentcosts.Critical Success Factors. The following list details the critical success factors for thewhole-of-enterprise model: changing customer behavior to make use of the new model,as opposed to the customer continuing to interact directly with individual units; reducingcosts in the individual business units as the direct demands on them fall, and managingthe transfer pricing issues that will inevitably arise; altering the perspective of thebusiness units to take an enterprise-wide view, which includes broad product awareness,training, and cross-selling; in the integrated implementation, reengineering the businessprocesses to link to life events at the front end and existing legacy processes and systemsat the back end; and finding compelling and practical life events that customers can useas triggers to access the enterprise.

Intermediaries

Intermediaries such as portals, agents, auctions, aggregators, and other intermediaries.E-business is often promoted as an ideal way for sellers and buyers to interact directly,shortening old-economy value chains by disintermediating some of their members. Yetsome of the most popular sites on the Internet, both for consumers and for businessusers, are in fact intermediaries—sites that stand between the buyer and the seller. Theservices of intermediaries include search (to locate providers of products and services),specification (to identify important product attributes), price (to establish the price,including optional extras such as warranties), sale (to complete the sales transaction,including payment and settlement), fulfillment (to fulfill the purchase by delivering the



product or service), surveillance (to conduct surveillance of the activities of buyers andsellers in order to report aggregate activity and prices and to inform and regulate themarket), and enforcement (to enforce proper conduct by buyers and sellers). Examplesof intermediaries are e-malls, shopping agents, specialty auctions, e-markets, e-auctions,and portals.Infrastructure. Intermediaries generate value by concentrating information and bringingtogether buyers and sellers, operating entirely in space and thus relying on IT as theprimary infrastructure. Weill and Vitale (2001) find in their field interviews that the mostimportant infrastructure services for firms pursuing the intermediary atomic businessmodel are the following: knowledge management, including knowledge databases andcontact databases that enable the codification and sharing of knowledge in this highlyinformation-intensive business; enforcing Internet and e-mail policies to ensure properand consistent use of electronic channels to buyers, sellers, and intermediaries; work-station networks to support the products and services of this all-electronic businessmodel; centralized management of e-business applications, ensuring consistency andintegration across product offerings; IS planning to identify the most effective uses ofIT in the business; and IS project management to ensure that business value is achievedfrom IT investments.Sources of Revenue. An intermediary may earn revenues from buyers, sellers, or both.Sellers may pay a listing fee, transaction fee, sales commission, or some combinationthereof. Similarly, buyers may pay a subscription fee, success fee, or sales commission.Critical Success Factors. The chief requirement for survival as an intermediary issufficient volume of usage to cover the fixed costs of establishing the business and therequired infrastructure. Attracting and retaining a critical mass of customers is thereforethe primary critical success factor. Another important critical success factor is buildingup infrastructure just quickly enough to meet demand as it increases.

Shared Infrastructure

The firm provides infrastructure shared by its owners. Other suppliers, who are users ofthe shared infrastructure but not owners, can also be included. Customers who accessthe shared infrastructure directly are given a choice of suppliers and value propositions.The owner and the nonowner suppliers are generally represented objectively. In somesituations, goods or services flow directly from the shared infrastructure to the customer.In other situations, a message is sent by the shared infrastructure to the supplier, whothen completes the transaction by providing the goods or services to the customer.An example illustrating the features of the shared-infrastructure business model is thesystem from 2000 by America’s largest automakers, some of their dealers, and IBM,Motorola, and Intel. The initiative was named Covisint (collaboration vision integrity).General Motors, Ford, and DaimlerChrysler see stronger potential benefits from coop-erating on supply-chain logistics than from competing with each other.Infrastructure. The shared-infrastructure business model requires competitors to coop-erate by sharing IT infrastructure and information. This level of cooperation requiresagreement on high-level IT architectures as well as operational standards for applica-



tions, data communications, and technology. Effective implementation of the shared-infrastructure model also requires enforcement of these standards, and most shared-infrastructure models have a joint committee to set and enforce standards. Another roleof these committees is to implement the policies of the shared infrastructure about whatinformation, if any, is shared and what information is confidential to partner firms. Weilland Vitale (2001) find in their field research that the most important infrastructure servicesrequired by firms implementing the shared-infrastructure atomic business model allconcerned architectures and standards: specification and enforcement of high-levelarchitectures for data, technology, applications, communications, and work that areagreed to by alliance partners; and specification and enforcement of detailed standardsfor the high-level architectures.Sources of Revenue. Revenues can be generated both from membership fees and fromtransaction fees. The alliance may be run on a nonprofit basis or on a profit-making basis.Not-for-profit shared infrastructures are typically open to all eligible organizations anddistribute any excess revenues back to their members. The for-profit models are typicallyowned by a subset of the firms in a given segment, which split up any profits amongthemselves.Critical Success Factors. Critical success factors for the shared-infrastructure modelinclude the following: no dominant partner that gains more than any other partner; anunbiased channel and objective presentation of product and service information; criticalmass of both alliance partners and customers; management of conflict among theongoing e-business initiatives of the alliance partners; compilation and delivery ofaccurate and timely statements of the services and benefits provided to each member ofthe alliance; and interoperability of systems.

Virtual Community

Virtual communities deserve our attention, and not only because they are the clearest,and perhaps the last, surviving embodiment of the original intent of the Internet. By usingIT to leverage the fundamental human desire for communication with peers, virtualcommunities can create significant value for their owners as well as for their members.Once established, a virtual community is less susceptible to competition by imitationthan any of the other atomic business models. In this business model, the firm ofinterest—the sponsor of the virtual community—sits in the center, positioned betweenmembers of the community and suppliers. Fundamental to the success of this model isthat members are able, and in fact are encouraged, to communicate with one anotherdirectly. Communication between members may be via e-mail, bulletin boards, onlinechat, Web-based conferencing, or other computer-based media, and it is the distinguish-ing feature of this model. Examples of this model are Parent Soup (www.parentsoup.com),a virtual community for parents, and Motley Fool (www.motleyfool.com), a virtualcommunity of investors.Infrastructure. Virtual communities depend on IT to exist. In particular, the creation andcontinual enhancement of an Internet site is essential if a virtual community is to survive.Many virtual-community sites include not just static content and links, but also tools ofinterest to potential members. Weill and Vitale (2001) find in their field research that the



infrastructure services most important for the virtual-community business model are thefollowing: training in the use of IT for members of the community; application serviceprovision (ASP) to provide specialized systems virtual communities need such asbulletin boards, e-mail, and ISP access; IT research and development, including infra-structure services for identifying and testing new technologies and for evaluatingproposals for new IS initiatives; IS planning to identify and prioritize potential invest-ments in IT in this completely online business; and installation and maintenance ofworkstations and local area networks to support the electronic world of the virtualcommunity.Sources of Revenue. A sponsoring firm can gain revenue from membership fees, directsales of goods and services, advertising, and click-through and sales commissions. Afirm sponsoring a virtual community as an adjunct to its other activities may receive nodirect revenue at all from the virtual community. Rather, the firm receives less tangiblebenefits, such as customer loyalty and increased knowledge about its customer base.Critical Success Factors. The critical success factors for a virtual community includefinding and retaining a critical mass of members; building and maintaining loyalty withan appropriate mix of content and features; maintaining privacy and security for memberinformation; balancing commercial potential and members’ interests; leveraging memberprofile information with advertisers and merchants; and engendering a feeling of trustin the community by its members.

Value Net Integrator

Traditionally, most firms operate simultaneously in two worlds: the physical and thevirtual. In the physical world, goods and services are created in a series of value-addingactivities connecting the supply side (suppliers, procurement, and logistics) with thedemand side (customers, marketing, and shipping). In the virtual world, informationabout the members of the physical value chain are gathered, synthesized, and distributedalong the virtual value chain. E-business provides the opportunity to separate thephysical and virtual value chains. Value net integrators take advantage of that split andattempt to control the virtual value chain in their industries by gathering, synthesizing,and distributing information. Value net integrators add value by improving the effective-ness of the value chain by coordinating information. A pure value net integrator operatesexclusively in the virtual value chain, owning a few physical assets. To achieve thegathering, synthesizing, and distributing of information, the value net integrator receivesand sends information to all other players in the model. The value net integratorcoordinates product flows from suppliers to allies and customers. The product flows fromthe suppliers to customers may be direct or via allies. In some cases the value netintegrator may sell information or other products to the customer. The value netintegrator always strives to own the customer relationship with the other participants inthe model, thus knowing more about their operations than any other player. Examples ofvalue net integrators are Seven-Eleven Japan and Cisco Systems (www.cisco.com).Infrastructure. The value net integrator succeeds in its role by gathering, synthesizing,and distributing information. Thus, for a value net integrator, data and electronicconnectivity with allies and other players are very important assets. Field research



carried out by Weill and Vitale (2001) suggests that the most important infrastructureservices required for a value net integrator include middleware, linking systems ondifferent platforms across the many players in the value net; a centralized data warehousethat collects and summarizes key information for analysis from decentralized databasesheld by several players across the value net; specification and enforcement of high-levelarchitectures and detailed standards for data, technology, applications, and communi-cations to link together different technology platforms owned by different firms; callcenters to provide advice and guidance for partners and allies in getting the most valuefrom the information provided by the value net generator; and high-capacity communi-cations network service to support the high volumes of information flowing across thevalue net.Sources of Revenue. In this model, revenues are generally earned by fees or margins onthe physical goods that pass through the industry value net. By using information aboutconsumers, the value net integrator is able to increase prices by meeting consumerdemand. By using information about suppliers, the value net integrator reduces costs bycutting inventories and lead times.Critical Success Factors. The critical success factors for the value net integrator atomicbusiness model are as follows: reducing ownership of physical assets while retainingownership of data; owning or having access to the complete industry virtual value chain;establishing a trusted brand recognized at all places in the value chain; operating inmarkets where information can add significant value, such as those that are complex,fragmented, regulated, multilayered, inefficient, and large with many sources of informa-tion; presenting the information to customers, allies, partners, and suppliers in clear andinnovative ways that provide value; and helping other value chain participants tocapitalize on the information provided by the value net integrator.

Content Provider

Like many terms associated with e-business, content provider has different meanings todifferent people. We define content provider as a firm that creates and provides content(information, products, or services) in digital form to customers via third parties. Thephysical-world analogy of a content provider is a journalist, recording artist, or stockanalyst. Digital products such as software, electronic travel guides, and digital music andvideo are examples of content. A virtual-world example of a content provider is weatherforecasters such as Storm Weather Center (www.storm.no).Infrastructure. Content providers must excel at tailoring and manipulating their corecontent to meet the specific needs of customers. Content providers must categorize andstore their content in well-indexed modules so that it can be combined and customizedto meet customer needs via a wide variety of channels. Customers and transactions tendto be relatively few, at least compared with the number of end consumers and theirtransactions. Often complex and unique IT infrastructures are needed to support theparticular needs of the specialized professionals employed by the content provider. Fieldresearch by Weill and Vitale (2001) identify the most important infrastructure services:multimedia storage farms or storage area network infrastructures to deal with largeamounts of information; a strong focus on architecture, including setting and enforcing



standards particularly for work; detailed data architectures to structure, specify, linkmanipulate, and manage the core intellectual property; workstation network infrastruc-tures to enable the fundamentally online business of a content provider; and a commonsystems development environment to provide compatible and integrated systems,ensuring the systems can provide content across multiple channels to their customers.Sources of Revenue. The primary source of revenue for a content provider is fees fromits third parties or allies. These fees may be based on a fixed price per month or year, oron the number of times the third party’s own customers access the content. In somesituations, the fees paid are lower for content branded by the provider, and higher forunbranded content, which then appears to the customer to have been generated by thethird party itself.Critical Success Factors. To succeed, a content provider must provide reliable, timelycontent in the right format and at the right price. The critical success factors for this modelinclude the following: branding (the value of content is due in part to reputation),recognized as best in class (the business of content provision will be global andcompetitive), and network (establishing and maintaining a network of third partiesthrough which content is distributed).As firms integrate e-business into their existing business, they migrate from traditionalphysical business models to combined physical and virtual models. This shift increasesthe role of the IT infrastructure because information and online transaction processingbecome more important. However, the large number of infrastructure investment optionscan easily overwhelm senior management. To help, Weill and Vitale (2002) classify e-business initiatives by the building blocks they use (which are called atomic e-businessmodels), and they examine the main IT infrastructure services that these models need.The business models require surprisingly different IT infrastructure services, so catego-rization should help executives prioritize their IT infrastructure investments based ontheir business goals. At the heart of this prioritization process is the firm’s IT governanceprocess, which should ensure that IT knows of upcoming IT infrastructure needs earlyin the strategizing process.Weill and Vitale (2002) define a firm’s IT portfolio as its total investment in computingand communications technology. The IT portfolio thus includes hardware, software,telecommunications, electronically stored data, devices to collect and represent data,and the people who provide IT services.

IT Infrastructure

The foundation of an IT portfolio is the firm’s IT infrastructure. This internal ITinfrastructure is composed of four elements: IT components (the technologist’s view ofthe infrastructure building blocks), human IT infrastructure (the intelligence used totranslate the IT components into services that users can draw upon), shared IT services(the user’s view of the infrastructure), and shared and standard applications (fairly stableuses of the services) (Weill & Vitale, 2001). The four elements are illustrated in Figure3.6.IT Components. At the base of the internal infrastructure are the technical components,such as computers, printers, database software packages, operating systems, and



scanners. These components are commodities and are readily available in the market-place. Traditionally, IT infrastructures have been described in terms of these compo-nents. Unfortunately, while technologists understand the capabilities of these compo-nents, business people do not—components are not business language to them. Thus,technologists and business people have had difficulty discussing infrastructure needsand business models because they have not had a common language.Human IT Structure. Describing IT components in business terms requires a translation.That translation is handled by people, and is performed in this layer, which builds on theIT components layer. The human IT infrastructure layer consists of knowledge, skills,standards, and experience. These tools are used to bind IT components into reliableservices, which are services business people can understand.Shared IT Services. This layer views the infrastructure as a set of services that users canunderstand, draw upon, and share to conduct their business. For example, to link withcustomers and partners, they can draw on channel management services. To managedata, they can draw on data management services. To handle security, they can draw onsecurity and risk services. Nine service areas are needed by IT-enabled businessmodels—with 70 services in all. Therefore describing IT infrastructure as a set of reliableservices allows business people and technologists to discuss business models and theirunderlying infrastructure needs because the two parties speak the same language.Shared and Standard Applications. The top piece of the IT infrastructure consists ofstable applications, such as human resource management, budgeting, and accounting.In the last five to seven years, there has been a significant trend by multibusiness firmsto standardize their common business processes and the associated IT applications. Thedriver for some firms was improving and reengineering their business processes; forothers, it was implementation of large ERP systems. As a result, shared and standardapplications have been added to the typical firm’s IT infrastructure.

Figure 3.6. The hierarchy of IT infrastructure

Local

applications Shared and standard

IT applications

Shared-information technology services

Human information technology infrastructure

Information technology components

Fast-changing local business applications such as project man-agement, executive IS, and groupware

Slow-changing global business applications such as accounting and human resources management

Humans with knowledge, skills, poli-cies, standards, experience, and so

Slow-changing services such as customer database and

Commodities such as computers, print-ers, routers, and database software



Based on these layers, a firm’s IT infrastructure capability is its integrated set of reliableIT infrastructure services available to support both existing applications and newinitiatives. The time required to implement a new e-business initiative depends in part onthe firm’s infrastructure capability. For example, in building a new Web-based housingloan system, a large bank needed to use the following IT infrastructure services:mainframe and server processing, customer databases, both local area and nationalcommunications networks, and security procedures and systems. Having most of theseinfrastructure services already in place significantly reduced the time and cost to buildthe loan system.

Infrastructure Services

Weill and Vitale (2001) identify nine service areas with 70 services needed by IT-enablede-business models. The service areas are (number of services in parentheses): applica-tions infrastructure (13), communications (7), data management (6), IT management (9),security (4), architecture and standards (20), IT research and development (2), and ITeducation (2), as listed in Figure 3.7.These 70 infrastructure services were identified by Weill and Vitale (2001) when theystudied IT infrastructure services and e-business. They studied 50 e-business initiativesin 15 firms. Based on their study, they identified eight atomic business models, nineinfrastructure areas with 70 infrastructure services. The nine infrastructure areas weredefined as follows:

• Applications infrastructure. An application is a software program that resides ona computer for the purpose of translating electronic input into meaningful form.Applications management includes purchasing software, developing proprietaryapplications, modifying applications, providing installation and technical support,and other tasks related to ensuring that applications are meeting the needs of theorganization.

• Communications. Technology that facilitates digital communication both withinthe organization and with the outside world is relevant here. It includes themanagement of hardware and software to facilitate communication via computer,telephone, facsimile, pagers, mobile phones, and other communication and mes-saging services. It includes the cabling and any other communication linkagesrequired to create an effective communications network, in addition to the neces-sary hardware and applications to meet the needs of the organization.

• Data management. This refers to the way the organization structures and handlesits information resources. Data may be sourced from internal or external databases.Data management includes data collection, database design, sorting and reportinginformation, creating links to external databases, assuring data compatibility, andother activities surrounding the effective management of electronic information.

• IT management. IT management includes many of the professional and strategicactivities of the IT group including negotiation, IS planning, project management,



Figure 3.7. E-business infrastructure service

Applications infrastructure

1. Internet policies such as employee access

2. Enforce Internet policies

3. E-mail policies such as inappropriate and personal mail, harassment policies, filteringpolicies

4. Enforce e-mail policies

5. Centralized management of e-business applications such as common standards

6. Centralized management of infrastructure capacity such as server traffic

7. Integrated mobile computing applications such as access for internal users

8. ERP services

9. Middleware linking systems on different platforms

1 0 . Wireless applications such as Web applications for wireless devices

11 . Application services provision to business units

12 . Work flow applications such as groupware

13 . Payment transaction processing such as EFT (electronic funds transfer)

Communications

1 4 . Communications network services

15 . Broadband communication services

1 6 . Intranet capabilities to support publishing, directories, and so forth.

17 . Extranet capabilities to support information and applications

18 . Workstation networks

1 9 . EDI (electronic data interchange) linkages to customers and suppliers

20 . Electronic support to groups

Data management

2 1 . Manage key data independent of applications

2 2 . A centralized data warehouse that summarizes key information from decentralizeddatabases

23 . Data management advice and consultancy

24 . Electronic provision of management information

2 5 . Storage farms or storage area networks

26 . Knowledge management in terms of contract database, information databases, andcommunities of practice

IT management

2 7 . Large-scale data-processing facilities

2 8 . Server farms including mail server, Web servers, and printer servers

29 . Installation and maintenance of workstations and local area networks

3 0 . IS planning for strategy

3 1 . IS project management

3 2 . Negotiate with suppliers and outsourcers



33 . Service-level agreements

3 4 . Common systems development environment

3 5 . Pilot e-business initiatives such as pilot Web shop fronts

Security

36 . Security policies for use of IS

3 7 . Enforce security policies for IS

38 . Disaster planning for business applications

39 . Firewall on secure gateway services

Architecture and standards

4 0 . Specify architectures for data by setting high-level guidelines for data use and integration

41 . Specify architectures for technology by setting high-level guidelines for technology use andintegration

4 2 . Specify architectures for communications by setting high-level guidelines for communicationsuse and integration

4 3 . Specify architectures for applications by setting high-level guidelines for applications use andintegration

4 4 . Specify architectures for work by setting high-level guidelines for the way work will beconducted

45 . Enforce architectures for data

46 . Enforce architectures for technology

47 . Enforce architectures for communications

48 . Enforce architectures for applications

4 9 . Enforce architectures for work

50 . Specify architecture standards for data

51 . Specify architecture standards for technology

52 . Specify architecture standards for communications

53 . Specify architecture standards for applications

54 . Specify architecture standards for work

55 . Enforce architecture standards for data

56 . Enforce architecture standards for technology

57 . Enforce architecture standards for communications

58 . Enforce architecture standards for applications

5 9 . Enforce architecture standards for work

Channel management

60 . Electronic file transfer protocols

6 1 . Kiosks

62 . Web sites

6 3 . Call centers

Figure 3.7. E-business infrastructure service, cont.



and other tasks. IS project management is defined as the coordination and controlof all of the activities required to complete an IS project.

• Security. To protect data, equipment, and processing time, organizations restrictaccess to certain data, and they protect data and applications from manipulationand contamination. Recovery refers to the need for a plan to maintain computeroperations and information should a disaster occur.

• Architecture and standards. IT architecture is a set of policies and rules thatgovern the use of IT and plot a migration path to the way business will be done inthe future. In most firms it provides technical guidelines rather than rules fordecision making. Architecture has to cope with both business uncertainty andtechnological change, making it one of the most difficult tasks for a firm. A goodarchitecture evolves over time and is documented and accessible to all managersin the firm. Each architecture decision needs a sound business base to encouragevoluntary agreement and compliance across the business. A standard is a detaileddefinition of the technical choices to implement architecture. Five elements ofarchitectures and standards are important: data, technology, communications,applications, and work. It can be distinguished between specifying architecture orstandards and enforcement.

• Channel management. New and emerging technologies allow direct connectionsor distribution channels to customers. Examples here are kiosks, call centers, mobilephones, and other means of communications.

• IT research and development. The IS market develops rapidly, particularly with therise of new e-business technologies. It is thus necessary to continually testapplications and hardware to assist with planning decisions. IT research anddevelopment includes identifying and testing new technologies for businesspurposes and evaluating proposals for new IS initiatives.

• IT education. Training and education in the use of IT can be defined as formalclasses, individual training, and technology-based self-training programs forusers ensuring hands-on computer proficiency levels meeting corporate require-

6 4 . IVRs

6 5 . Mobile phones

66 . Mobile computing

IT research and development

67 . Identify and test new technologies for business purposes

6 8 . Evaluate proposals for new IS initiatives

IT education

69 . Training and use of IT

7 0 . Management education for generating value from IT use

Figure 3.7. E-business infrastructure service, cont.



ments. IS management education can be defined as education aimed at senior levelsin the firm designed to generate value from IT use.

Services Outsourcing

Successfully implementing e-business initiatives depends on having the necessary ITinfrastructure in place. E-business initiatives can be decomposed into their underlyingatomic e-business models, which can have quite different IT infrastructure requirements.It is important for outsourcing vendors providing IT infrastructure services to under-stand which atomic e-business models are represented in the firm’s anticipated e-business initiative. Senior customer management has to design a process to involvevendor management in e-business strategizing, both to get IT input into businessstrategy and to provide the vendor with an early warning of what infrastructure serviceswill be critical.

Vendor Value Proposition

The value generation potential of an outsourcing relationship consists of three factors:client characteristics, the vendor–client relationship, and vendor characteristics. A keyclient characteristic is an understanding of how to manage resources that a firm does notown. A key in the vendor-client relationship is formal (contractual) aspect of therelationship. The third factor shaping the outsourcing value proposition is the vendor’sown capabilities. From an outsourcing vendor’s perspective, there are many potentialopportunities and benefits for the client. These opportunities and benefits can be derivedfrom the IT outsourcing vendor’s value proposition. Important vendor characteristicsinclude capabilities such as technical competence, understanding of the customer’sbusiness, and relationship management. Our presentation and discussion in the follow-ing text of this third factor in terms of vendor value proposition is based on a researcharticle by Levina and Ross (2003).To date, most research in IT outsourcing concludes that firms decide to outsource ITservices because they believe that outside vendors possess production cost advan-tages. Yet it is not clear whether vendors can provide production cost advantages,particularly to large firms that may be able to replicate vendors’ production costadvantages in-house. Mixed outsourcing success in the past decade calls for closerexamination of the IT outsourcing vendor’s value proposition. The concepts of comple-mentaries and competencies explain that outsourcing vendors can increase productivityand reduce costs on client projects by applying a set of complementary applicationmanagement competencies. This is the vendor value proposition.The concept of complementarity posits that firms can improve productivity by engagingin complementary activities where benefits from doing more of one activity increase ifthe firm is also doing more of the other activity. This concept of complementarity has beenused in studies of manufacturing to show that modern manufacturing approaches work



as a system, rather than as a set of independent factors. Those firms that investsimultaneously in several complementary activities perform better than those firms thatincrease the level of some of these activities but not others. In fact, literature oncomplementarity argues that firms that increase one factor without also increasingcomplementary factors may be worse off than firms that keep the factors at the same lowerlevel.An outsourcing vendor may develop different competencies. In the case study by Levinaand Ross (2003), the vendor developed a set of three competencies to respond to clientneeds and market demands: personnel development, methodology development anddissemination, and customer relationship management:

• IT personnel development addressed existing IT labor market constraints by thevendor in ways that the client had not. The vendor replaced experienced, high-costclient staff with mostly lower-cost, junior programmers and then developed theirskills through training, mentoring, and team-based project work. Junior staff valuedthe professional growth while their mentors often relished opportunities to watchsomeone take off. As a professional services firm, the vendor viewed maintenancework as a first step in a career development path, which involved rotatingprofessionals within engagements, assigning personnel development managers,and creating both technical and management hierarchies.

• Methodology development and dissemination was necessary for consistentdelivery of best-of-breed solutions to client problems. Whereas the client’s stafffocused on addressing users’ immediate needs, the vendor introduced methodolo-gies that focused on overall operational improvements on projects. The vendor hada long history of methodology development. The methodologies not only specifiedprocesses, but they also standardized project documentation through forms andtemplates, such as change request forms, lost time logs, and weekly status reportforms, to closely monitor project status.

• Customer relationship management was formalized through level of serviceagreements. Each agreement set a fixed price for agreed-upon services. The majorphilosophy of outsourcing was that the vendor is taking a risk. The vendor isresponsible for whatever is defined in that client interface document as being thevendor’s responsibility. While agreements might not lead to greater user satisfac-tion with the level of IT services, it did reduce uncertainty, thereby creating clearerexpectations and an acceptance of limits. As users accepted these limits, theyrecognized and appreciated services that exceeded contract requirements.

These three competencies turned out to be complementary by being mutually reinforc-ing. Management practices targeted at one competency tended to enhance the othercompetencies as well. This reinforcing pattern was apparent in all three pairings of thecompetencies:

• Personnel development and methodology development and dissemination arecomplementary competencies. The methodology competency reinforced person-



nel development by helping junior staff learn quickly what they were expected todo. While methodologies were sometimes viewed as constraining individualinitiative, one junior consultant argued that the methodology empowered her andothers to challenge management directives that might be inconsistent with docu-mented practices. In addition, standardization of practices around methodologyfacilitated staff rotations and scheduling. In the same way, personnel developmentpractices, such as skill development, rotations, and promotion policies, providedtraining, encouragement, and incentives that led to consistent use and improve-ment of methodologies across the organization.

• Methodology development and dissemination and customer relationship arecomplementary competencies. When methodology delivered operational improve-ments, the vendor could sometimes increase service levels with no added cost tothe client. In some cases, the vendor had been able to pull people off a project andhad elected to share the savings with the client. These very visible improvementsin IT service levels reinforced the customer relationship. Methodological ap-proaches also improved customer relationship management practices by definingand standardizing best practices for creating and managing level of serviceagreements. The customer relationship management competence similarly rein-forced the methodology competence. The vendor regularly communicated with theclient to discuss issues and expectations, and one outcome was to help the clientmanagers understand the methodologies so that they could facilitate, rather thanhinder, the vendor’s ability to meet expectations. Thus, client managers sharedtheir knowledge of systems with the vendor and provided early warnings, wherepossible, when business or corporate IT changes might have an impact on thevendor’s responsibilities.

• Personnel development and customer relationship are complementary compe-tencies. Personnel development practices reinforced customer relationships byensuring that staff understood and accepted accountability for meeting contrac-tual obligations. Personnel development practices also developed communicationskills to help staff establish customer expectations and build trust. At the same time,strong customer relationships led to better buy-in, on the customer’s part, topersonnel development policies that required release time or movement of person-nel, such as training programs, mentoring, and job rotations.

The concepts of complementaries and core competencies explain that the vendor canincrease productivity and reduce costs on client projects by applying this set ofcomplementary application management competencies. Levina and Ross (2003) examinehow the vendor delivers value to clients as a result of its ability to develop complementarycompetencies. First, they went beyond neoclassical economics theory to explain whypotential clients are unlikely to develop these complementary competencies internally.They then explored the mechanisms that ensure that the benefits of the vendor’scompetencies are, in part, passed on to clients.

• Why clients do not replicate and apply vendors’ competencies. Typically, clientshave a different set of market structures and resource constraints than the IT



services industry. Accordingly, clients have a different organization and differentbusiness processes. Clients have hired personnel to address the market conditionsand customer demands of their industry. Clients can attempt to build IT applicationcompetencies rather than outsource to vendors, but unlike vendors, they may findthat optimizing the development and application of IT competencies will conflictwith optimizing core business activities. Vendors, on the other hand, can shieldthemselves from these conflicts through the structure provided by contracts,which specify deliverables rather than levels of investment in competencies.

For example, to address labor market constraints, clients could increase the compensa-tion of technical specialists, but non-IT workers might perceive the inflated IT salariesas unfair. Similarly, clients are typically not as well positioned as vendors to institute anIT personnel career development office or a practice of IT personnel rotation andpromotion.

• Why vendors share productivity gains with clients. From the client perspective,the vendor’s value proposition would not exist if the benefits of complementarycompetencies accrued solely to the vendor. Contract-based, interpersonal, andreputation-based mechanisms encourage vendors to share advantages with cli-ents. Clients may deploy some contract-based mechanisms including pilot projects,multiphase contracting with penalties, interpersonal relationship building, carrot-and-stick incentives and short-term contracts, and competent contract monitoring.All of these mechanisms increase client control and motivate vendors to demon-strate value to the client. Since the value of outsourcing to the client is very hardto measure, most researchers have focused on client satisfaction.

Reputation-based mechanisms provide vendors with a strong incentive to share produc-tivity gains with clients. IT service vendors’ focus on reputation building in theirrelationships with clients. In addition to their current contracting structure, vendors careabout their long-term market position. Thus, the vendor is inclined to share benefits withthe client so that the information about the vendor’s contribution enables it to win futurecontracts. Developing a solid industry reputation helps a vendor win new, and extendexisting, engagements, which lead to the acquisition of, and control over, more projects.Knowledge-intensive service firms such as outsourcing vendors are typical value shops(Gottschalk, 2005), and such firms depend on reputation for success, as reputation is akey driver of firm value creation. Reputation is a relational concept in the sense that firmsare judged by their stakeholders relative to their competitors. Reputation is what isgenerally said or believed about an entity by someone, it is the net perception of a firmheld by stakeholders judged relative to other firms. According to Sheehan (2002), thereare four conditions, which must be present for reputation to work. First, rents earned frommaintaining a good reputation must be greater than not. Second, there must be a minimumof contact among stakeholders to allow for the changes in reputation to be communi-cated. Third, there needs to be a possibility of repeat business. And last, there must besome uncertainty regarding the firm’s type and/or behavior.



Reputation is related to the asymmetry of information, which is a typical feature ofknowledge-intensive service firms. Asymmetry is present when clients believe the firmknows something that the clients do not and believe it is necessary to know to solve theirproblems.Reputation can be classified as a strategic resource in knowledge-intensive firms. To bea strategic resource, it has to be valuable, rare, and costly to imitate, and possible toorganize. Reputation is valuable as it increases the value received by the client.Reputation is rare, as by definition only a few firms can be considered best in the industry.Reputation is costly to imitate, as it is difficult to build a reputation in the short run.Reputation is possible to organize in the general sense of controllability, which impliesthat a firm can be organized to take advantage of reputation as a resource.The vendor’s strategy and practices are depicted in Figure 3.8. This model of the ITvendor’s value proposition suggests that client needs, as shaped by market constraints,specify the requirements for client satisfaction. Client satisfaction results from servicesprovided by vendors through the application of a complementary set of core competen-cies targeted at delivering higher service at a lower marginal cost.Client satisfaction is achieved in Figure 3.8 when the application of core competenciesto projects is enabled by healthy client-vendor relationship, which is in part influencedby the vendor’s expertise in managing client relationships. Competencies, in turn, growthrough the vendor’s firm-wide experience gained from controlling a large number andvariety of projects, which, in turn, grow due to the reputation the vendor developsthrough its ability to satisfy customers. The model represents a set of positive feedbackloops, which will result in negative outcomes if, for example, the competencies do notmatch client needs.

Figure 3.8. Vendor’s value proposition (Levina & Ross, 2003)

Contract-based mechanisms

Applications Management Market Characteristics

Client needs � Rapid response to business

and technological changes

� Kostnads-effektivitet

IT Labor Constraints � High level of turnover

� Rise of IT workers salaries

� Scarcity of advanced technical skills

� Reward for skills updating

defines Client satisfaction

Number and variety of projects controlled by the vendor

Vendor practice

increases

drives

leads to higher

Reputation-based mechanisms

Personnel Methods

Customer relationships

Complimentary competencies:

Interpersonal mechanisms



IT Function Organization

Outsourcing implies choice of principle and model for organizing the IT function. Tounderstand implicit opportunities and threats involved in such principle and modeldecision making, we will present all principles and models for organizing the IT functionas described by Agarwal and Sambamurty (2002). Three principles underlie new ways toorganize the IT function:

• Principle 1: Organize IT to foster coevaluation between the business and ITfunction. Design reporting relationships for key IT executives that focus onstrategic business drivers. Engage IT executives in experimenting with new IT-enabled business models and business practices through appropriate incentives.

• Principle 2: Organize IT to nurture relationship networks for visioning, innova-tion, and sourcing. Nurture internal coordination mechanisms, including executivecouncils, IT management councils, divisional steering councils, IT standing teams,account managers, divisional information officers, service-level agreements, andinformal relationship building. Nurture external partnering tactics, such asmultisourcing agreements, strategic alliances, and joint ventures.

• Principle 3: Organize IT to explicitly manage eight value-creating processes.Adopt a modular approach to selecting optimal organizing options for individualvalue-creating IT processes. There are eight value-creating processes consistingof three foundation processes (infrastructure management, human capital manage-ment, relationship management), three primary processes (value innovation, solu-tions delivery, services provisioning), and two secondary processes (strategicplanning, financial management).

Outsourcing implies choice of Principle 2 as the dominating principle. According to thisprinciple, sourcing networks are important. Sourcing networks are relationship networksbetween IT executives and external partners. Their purpose is to foster collaborationbetween these internal and external parties when they are negotiating and managingefficient, cost-effective, and innovative uses of IT assets and services through sourcingarrangements, joint ventures, and strategic alliances. Three organizational models aretypically found in companies:

1. The Partner Model primarily aims to ensure that the IT function is an active anddirect participant in collaborating with business executives to make businessinnovation through IT a reality.

2. The Platform Model primarily aims to ensure that the IT function provides theassets, services, and resources for business innovation across the enterprise.Thus, the IT function acts as an enabler of innovation rather than as a direct catalystfor innovation, as in the partner model.

3. The Scalable Model primarily aims for maximum flexibility in its people resources,so that the IT function can expand and contract in concert with business cycles.



A salient aspect of this model, in contrast with the other two models, is that it makesextensive use of sourcing relationships with vendors and systems integrators toachieve flexibility in IT resources.

Outsourcing implies the choice of model #3—the scalable mode—as the dominating ITfunction organization. This model seeks to facilitate IT-based business innovationwithout committing significant organizational investments to in-house IT resources. Thescalable model uses sourcing to be flexible. This model emphasizes sourcing networksto leverage external partners, particularly for two IT value-creating processes: solutionsdelivery and services provisioning. Creative sourcing relationships permit the ITfunction to control IT costs while changing staff size in response to cyclical businessconditions.Our application of the principles and models suggested by Agarwal and Sambamurthy(2002) to IT outsourcing implies that opportunities and threats can be understood interms of these principles and models. When outsourcing implies Principle #2, thenthreats are related to lack of coevolution with the rest of the business (Principle #1) andlack of management of all eight value-creating processes (Principle #3). When outsourcingimplies model #3, then threats are related to lack of participation in collaborating withbusiness executives to make business innovation and lack of proactive partnership ininnovation processes.

Outsourcing Performance

The rapidly increasing use of outsourcing for IT services, both in the public and privatesectors, has attracted much interest from researchers and practitioners alike. While earlystudies of IT outsourcing were largely qualitative in nature, more recent studies haveattempted to analyze the outcomes achieved in quantitative terms. Domberger, Fernandez,and Fiebig (2000) are consistent with the latter, but goes further by modeling the price,performance, and contract characteristics that are relevant to IT outsourcing. A two-equation recursive regression model was used to analyze 48 contracts for IT support andmaintenance. The results did not reveal any quantitatively significant price-performancetrade-off, but did suggest that first-term contracts (i.e., the first-ever contract awardedby a client for the provision of a particular IT service) were more expensive than repeatcontracts. Although competitive tendering did not result in lower prices than directlynegotiated contracts, it was associated with comparatively better performance. Well-defined expectations of an organization’s IT requirements were also likely to lead toimproved performance when the service was outsourced.Domberger et al. (2000) measured IT outsourcing performance by both desired perfor-mance and realized performance. Clients typically have an expectation of service qualityprior to awarding a contract. This can be referred to as desired performance. A necessarypart of contract management involves an assessment of the realized performance of thecontract. The clients responding to the study were asked to rate the desired performance



and realized performance of the contracts for each of the following eight serviceattributes:

1. Service availability and timeliness2. Out-of-hours availability3. Response in emergencies4. Provision at expected cost5. Delivery to expected quality6. Accuracy of advise7. Correctness of error fixes8. Minimization of system downtime

The original scale for the desired and realized performance ratings was from 1 to 4. A ratingof 1 corresponded to not important for the former and unsatisfactory for the latter, while4 corresponded to very important and excellent, respectively. Ratings that were notreported were filled with zeros to preserve the continuity of the scale on the assumptionthat they were considered irrelevant or very low in terms of desired or realized perfor-mance.The eight service attributes listed were taken to represent measures of quality. For thepurposes of analysis and estimation, a single quality/performance variable was sought.Here there were a number of choices. One possibility was to construct what is calledprincipal components. The first principal component, which explained approximately50% of the variation in the attributes, is essentially a simple average of the realizedratings. It turned out that the responses were all positively and highly correlated. Thus,the simple average of the ratings attached to the eight attributes represented a simple andreadily interpretable choice for a single performance variable.A second possibility was to consider the realized performance relative to the base, asrepresented by the desired performance ratings. Constructing a new set of attributes bysubtracting the desired from the realized rating for each attribute and contract results indata that has as its first principal component a variable which is essentially the simpleaverage. Once again this accounted for approximately 50% of the variation in the data.Thus, a second possible proxy for the performance variable is the average of the eightrealized minus desired attributes. Rather than choose between these alternative proxies,the results for both realized and differences were reported (Domberger et al., 2000). Meanof the eight realized performance ratings was 2.97. This result can be interpreted assatisfactory, but not excellent, indicating that the average response by the 48 firms wasthat they found realized performance to be satisfactory. Mean of the realized minusdesired performance ratings was 0.49. The negative mean for this performance variableindicates a slight tendency to underperform relative to the desired levels of servicequality.



Successful Relationships

We have entitled this book Managing Successful IT Outsourcing Relationships. Butwhat is success? In the study by Lambe, Spekman, and Hunt (2002b), alliance successwas operationalized through the following items: (1) we have achieved a high level of jointprofits between us, (2) we have generated a lot of profits together, and (3) we haveincreased joint profits shared between us. In the study by Lee and Kim (1999), successwas measured on two variables. The first variable, business perspective, had thefollowing items: (1) we have been able to refocus on core business, (2) we have enhancedour IT competence, (3) we have increased access to skilled personnel, (4) we haveenhanced economies of scale in human resources, (5) we have enhanced economies ofscale in technological resources, (6) we have increased control of IS expenses, (7) we havereduced the risk of technological obsolescence, (8) we have increased access to keyinformation technologies, and (9) we are satisfied with our overall benefits fromoutsourcing. The second variable, user perspective, had the following items: (1) reliabil-ity of information, (2) relevancy of information, (3) accuracy of information, (4) currencyof information, (5) completeness of information, and (6) timeliness of information. Mostof the other reviewed literature that touch on success apply the client perspective.However, successful IT outsourcing relationships require success for both client andvendor.For the vendor—as the source firm—an IT outsourcing relationship is successful if itgenerates profit for the company and if it strengthens the company’s value propositionin terms of complementary competencies such as IT personnel development, methodol-ogy development and dissemination, and customer relationship management (Levina &Ross, 2003). For the client—as the sourcing firm—an IT outsourcing relationship issuccessful if it generates profit for the company and if it contributes to achievement ofoutsourcing objectives as exemplified by Lee and Kim (1999). Managing successful IToutsourcing relationships means to us that source firm and sourcing firm both achievetheir objectives in a joint effort. Achieving objectives is a matter of outsourcing outcome.Outsourcing outcomes can be both planned and unplanned.

Outsourcing Opportunities

An empirical study of information technology sourcing in U.S. and U.K. organizationsidentified indicators of success. The objective of the study was to develop indicatorsof success based on participants’ perceptions of whether the outcome of their ITsourcing decisions met their expectations. Participants cited a variety of expectations(anticipated and hoped-for outcomes) and reasons (justifications and explanations) fortheir sourcing decisions. Fifteen categories of expectations/reasons for sourcing wereidentified (Lacity & Willcocks, 1998):



1. Reduce IT costs2. Improve technology or technical service3. Jump on the bandwagon—outsourcing perceived as a viable, irreversible trend

within their industry4. Focus business on core competencies—IT perceived as noncore5. Restructure IT budgets from capital budgets to fixed operating budgets6. Play good corporate citizen—IT managers perceive an outsourcing evaluation

demonstrates their willingness to subordinate the good of IT department for thegood of the overall business

7. Focus internal IT staff on critical IT activities, such as development, whileoutsourcing more stable and predictable IT activities, such as data center opera-tions

8. Prove efficiency—invite bids to receive a free benchmark9. Eliminate an IT burden; assume a vendor will solve problematic IT function(s)10. Downsizing—the entire company is pressured to reduce head count11. Preemptive move by IT managers to expose exaggerated claims made to senior

executives by consultants or vendors12. Improve cost controls13. Forced market testing by the government14. Justify new IT resources by bundling capital budget requests with a kind of proof

that vendors cannot do it cheaper15. Facilitate mergers and acquisitions—vendors are perceived as experts in merging

data centers quickly

Each participant’s expectations/reasons were mapped into the 15 chosen categories. Inmany instances, participants stated more than one expectation/reason. The ranking from1 to 15 was based on total responses from participants.Global outsourcing’s defenders list a number of arguments in favor of outsourcing.Arguments in favor of outsourcing can be broken down to five areas: concentration oncore business development by firms, cost control, access to state-of-the-art technology,market discipline through greater transparency, and added flexibility to respond todemand changes (Clott, 2004). The motivations for outsourcing are evolving from aprimary focus on cost reduction to an emerging emphasis on improving businessperformance. The traditional rationale of vendor economies of scale and specializationis becoming less convincing as companies with well-run, innovative IS departments thatare large enough to accrue the same scale and specialization benefits as a vendor, arenevertheless engaged in significant outsourcing deals.DiRomualdo and Gurbaxani (1998) discovered in their research that while the academicliterature and business press discuss IT outsourcing as if it were always driven by asingular focus on reducing the costs and enhancing the efficiency of IT resources, thisis in fact only one of three kinds of strategic intent for IT outsourcing. They called this



well-established intent IS Improvement. The other two have more recently emerged assignificant factors in many companies’ decision to outsource. Outsourcing for businessimpact focuses on improving IT’s contribution to company performance within theexisting lines of business. The third category of intent, commercial exploitation, focuseson leveraging technology-related assets in the marketplace:

• IS Improvement. Companies that want better performance from their core ISresources—the hardware, software, networks, people, and processes involved inmanaging and operating the technology and supporting users—have the strategicintent of IS improvement. Their objective typically includes cost reduction, servicequality improvement, and acquisition of new technical skills and managementcompetencies. They believe that outside specialists who are better able to keeppace with new technologies and skills, and who use superior processes andmanagement methods, should manage some, if not all, of their IT services.

• Business Impact. Many IS organizations are struggling to develop the right mix oftechnical and business skills to exploit technology. As a result, many companiesare looking to the IT outsourcing market for help, on the premise that outsourcingvendors’ state-of-the-art skills, capabilities, and proficiency at recruiting andmanaging technologists make them better than internal IS organizations at usingIT to improve business results. The strategic intent is deploying IT to significantlyimprove critical aspects of business performance.

• Commercial Exploitation. Outsourcing IT with the strategic intent of commercialexploitation aims to improve the return on IT investment by generating new revenueand profit or by offsetting costs. The means by which IT assets can be leveragedcommercially range from licensing systems and technologies developed initiallyfor internal use, through selling IS products and services to other firms, tolaunching new IT-based businesses. Our study discovered that companies pursu-ing commercial exploitation were often those with innovative IS. Many come fromtechnology-intensive industries, such as air transport and financial services, andhave mission-critical systems that are expensive to maintain and enhance.

Outsourcing Threats

While literature on outsourcing has often sought to draw lessons from highly visiblecompanies that have been successful in outsourcing, Barthélemy (2003b) in his articleon “The seven deadly sins of outsourcing” sheds light on failed efforts. Failed outsourcingendeavors are rarely reported because firms are reluctant to publicize them. Firms do notlike to report their failures because such information can damage their reputation. Hisstudy was based on in-depth analysis of 91 outsourcing efforts carried out by Europeanand North American firms. Through his survey, he found that the same mistakes underliemost failed outsourcing efforts. These mistakes have been termed the “seven deadly sinsof outsourcing”:



1. Outsourcing activities that should not be outsourced. Determining which activi-ties can be best performed by outside vendors requires a good understanding ofwhere the firm’s competitive advantage comes from. Resources and capabilitiesthat are valuable, rare, difficult to imitate, and difficult to substitute can beemployed to create superior performance. Activities that are based on suchresources and capabilities (i.e., core activities) should not be outsourced becausefirms risk loosing competitive advantage and becoming hollow corporations.

2. Selecting the wrong vendor. Selecting a good vendor is crucial for successfuloutsourcing. The literature has identified numerous criteria for successful providerchoice. A useful distinction can be made between hard and soft qualifications. Hardqualifications are tangible and can be easily verified by due diligence. They referto the ability of vendors to provide low-cost and state-of-the-art solutions.Important criteria also include business experience and financial strength. Softqualifications are attitudinal. They may be nonverifiable and may change depend-ing on circumstances. Important soft criteria include a good cultural fit, a commit-ment to continuous improvement, flexibility, and a commitment to develop long-term relationships.

3. Writing a poor contract. Since the 1980s, vendor partnerships have emerged as amodel of purchasing excellence. Partnerships replace market competition by closeand trust-based relationships with a few selected vendors. The notion thatoutsourcing vendors are partners and that contracts play a minor role waspopularized by early outsourcing deals. However, there are pitfalls in partnershipmanagement. A good contract is essential to outsourcing success because thecontract helps establish a balance of power between the client and the vendor.Spending too little time negotiating the contract and pretending that the partner-ship relationship with the vendor will take care of everything is a mistake. Draftinga good contract is always important because it allows partners to set expectationsand to commit themselves to short-term goals.

4. Overlooking personnel issues. The efficient management of personnel issues iscrucial because employees generally view outsourcing as an underestimation oftheir skills. This may result in a massive exodus even before an actual outsourcingdecision has been made. Firms that contemplate outsourcing must face twointerrelated personnel issues. First, key employees must be retained and motivated.Second, the commitment of employees transferred to the vendor must also besecured.

5. Loosing control over the outsourced activity. When the performance quality of anactivity is low, managers are often tempted to outsource it. If poor performance isattributable to factors such as insufficient scale economies or a lack of expertise,outsourcing makes sense. If poor performance is attributable to poor management,outsourcing is not necessarily the right solution. For an outsourcing client, it isparticularly important to avoid losing control over an outsourced activity. It iscritical to keep the outsourced activity in alignment with the overall corporatestrategy. While vendor management skills are very important, they must also becomplemented with technical skills. If no one in the company is able to assesstechnological developments, outsourcing is bound to fail.



6. Overlooking hidden costs of outsourcing. Outsourcing clients are generallyconfident that they can assess whether or not outsourcing results in cost savings.However, they often overlook costs that can seriously threaten the viability ofoutsourcing efforts. Transaction cost economics suggests two main types ofoutsourcing hidden costs. First, outsourcing vendor search and contracting costsare costs of gathering information to identify and assess suitable vendors andcosts of negotiating and writing the outsourcing contract. Second, outsourcingvendor management costs include monitoring the agreement to ensure thatvendors fulfill their contractual obligations, bargaining with vendors and sanction-ing them when they do not perform according to the contract, and negotiatingchanges to the contract when unforeseen circumstances arise.

7. Failing to plan an exit strategy. Many managers are reluctant to anticipate the endof an outsourcing contract. Therefore, they often fail to plan an exit strategy (i.e.,vendor switch or reintegration of an outsourced activity). Outsourcing relation-ships can be viewed on a continuum. At one end are long-term relationships whereone or both partners have made investments specific to the relationship. There isa considerable advantage in recontracting with the same vendor because switchingvendors or reintegrating the outsourced activity is very difficult. At the other endare market relationships where the client has a choice of many vendors and theability to switch vendors with little cost and inconvenience. In this case, there isno real advantage in recontracting with the same vendor.

Today, outsourcing has extended to more crucial activities such as IT, telecommunica-tions, finance, and logistics. Increasingly, complex types of outsourcing have devel-oped. Based on his survey of 91 outsourcing efforts, Barthélemy (2003b) found that thereare seven deadly sins of outsourcing, as summarized in Figure 3.9. Historically,

Figure 3.9. The seven deadly sins of outsourcing and lessons learned

Timetable # Deadly sin Lesson learned

Original idea to outsource 1 Outsourcing activities that

should not be outsourced

Only noncore business activities

2 Selecting the wrong ven-

dor

State-of-the art and trustworthy

vendors

3 Writing a poor contract Precise, complete, balanced, and

flexible contract

Beginning of the relationship 4 Overlooking personnel

issues

Good communication and ethical

behavior toward employees

5 Losing control over the

outsourced activity

Active management of the vendor

6 Overlooking the hidden

costs of outsourcing

Search, contracting, and managing

costs

Vendor switch or reintegration

of the outsourced activity

7 Failing to plan an exit

strategy

Building reversibility clauses into

the contract



outsourcing was restricted to basic support activities such as janitorial services. Somesins were “deadlier” than others. “Writing a poor contract” and “losing control over theoutsourced activity” had the largest impact on the outcome of outsourcing efforts. Onthe other hand, “failing to plan an exit strategy” was not a good differentiator betweensuccess and failure, perhaps because planning an exit strategy only becomes necessaryin the case of vendor switch or reintegration of an outsourced activity.Several years before Barthélemy, Earl (1996) identified risks of outsourcing. Accordingto him, there are many risks that, in practice, indicate limits to outsourcing. Those whohave outsourced have more regrets than they acknowledge and more anxieties aboutvendors than they care to confront. Chief information officers (CIOs) in firms that arecurrently on the cusp of deciding to outsource have confided apparently soundcautionary instincts, but momentum can be difficult to stop. Earl argues that the ITsourcing question should be rephrased to, “Why should we not insource IT services?”instead of, “Why should we outsource IT services?” by considering the following elevenrisks of outsourcing:

1. Possibility of weak management. If an IT service scores low on operationalperformance, a company will clearly be tempted to outsource it to a third party. Thisis true whether poor performance is real or imagined, or whether top management’sviews are rational or emotional. If the IT activity has been badly managed in the firstplace, will the IT managers be any better at managing an external provider? Indeed,does executive management want to give the benefits of improving an inefficientmanagement to the marketplace? Once outsourcing has been initiated, managingIT services on the outside is far from easy. If the third party is not necessarily better,a company has to enhance its management of vendor skills and placate users.Hence, to reduce initial risks in outsourcing, a company must first be capable ofmanaging the IT service.

2. Inexperienced staff. One argument for outsourcing is that specialist IT companiesare likely to have better IT specialists. While this might be true, relatively new ITservices businesses do not necessarily have either the best expertise or solidexperience. What is worse is that in facilities management contracts with even themost established IT service businesses, the customer’s staff may go work with thevendor. Transferring internal weak staff and then having to deal with them all overagain as contractor staff will not solve the problems. Since some of the largestoutsourcing contracts were initiated to transform a resistant and slack IS function,the risk becomes even starker. The biggest risk, however, may occur when a largeoutsourcing contract is awarded to a major vendor. Headhunters call their networkof contacts with a frantic request for someone who can manage a large facility thathas just been outsourced or anyone who has experience in managing contracts andcan head up a rapidly growing outsourcing division. If the candidate is someoneworking for the company that has just decided to outsource, the chances are thathe or she will be retained by the original company anyway, or will prefer to workfor another user company where his or her experience is better suited. Shrewdpersonnel policies can help mitigate some of the risks at the time an outsourcingcontract is signed. However, capable IT staff are rare, and there is a chance that thecustomer company will want to keep them or that they will decide to go elsewhere.



3. Business uncertainty. If a firm decides to outsource IT services because of costsor focus, it is assuming that its future direction and needs are clear. However, whencost is the driver of outsourcing, or converting fixed costs to variable costs is thedeclared aim, it is likely that the company will sacrifice crucial competencies orcapabilities. The IT marketplace may offer more variety in services and suppliersthan any corporation can. Thus, unknown future business needs may, in principle,be satisfied when they arise.

4. Outdated technology skills. When a company outsources an IT service to a thirdparty, how can the company be sure that the vendors’ skills stay current? If costreduction is the objective in an outsourcing deal, the hope is that the current costcase is reduced and that, over time, there are further cost reductions due to learningand technological change. Indeed, a company can force these improvements intothe contract at the outset or negotiate them at annual reviews. However, if thevendors’ skills do not advance, the cost-reduction potential is lessened, andunless further market testing is done, target setting is suboptimal.

5. Endemic uncertainty. IT operations and development have always been inherentlyuncertain. Users are not sure of their needs, new technology is risky, businessrequirements change, and implementation is full of surprises. A systems projectmanagement regime that demands no changes to specifications and rigid time andbudget controls can produce applications that do not achieve their full potentialor can create user–specialist conflicts. Companies should avoid outsourcingcontracts that are set in concrete. At the same time, contracts should be precise,complete, incentive based, balanced, and flexible, according to Barthélemy (2003a).However, being willing to pay for flexibility may be better than specifying tightperformance contracts with penalty clauses, followed by litigation.

6. Hidden costs. When cost reduction is the objective of outsourcing, there istypically a promise of early cash flow benefits and long-term cost savings. Thereare two tendencies, however, that are of concern. First, companies underestimatethe setup costs, including redeployment costs, relocation costs, and longer-than-expected handoff or parallel running costs. Second, companies may underestimatemanagement costs. Some companies never anticipated the management resourcesand time—and thus cost—that has to be put in. Companies rarely record the costsof management.

7. Lack of organizational learning. Much learning about the capability of IT isexperiential. Organizations tend to learn to manage IT by doing; they do notappreciate the challenges until they have experienced them. Management tends tolearn the value of IT applications (or of infrastructure) by using them and seeingfurther opportunities for development. Many strategic IS were discovered in anevolutionary fashion. Thus the strategic scope of systems often emerges as userslearn what is possible and as the business context and needs change. Of course,there is no reason that a third party cannot operate, enhance, or rebuild anapplication that has been reclassified as strategic. However, in other areas ofbusiness, responsibility for strategic assets is not so easily delegated to themarketplace.

8. Loss of innovative capacity. In the long run, a company wants to maintaininnovative capacity in IT because there will be new ways of providing IT services



and of exploiting IT for business. If the company has outsourced IT services anddownsized as well, its ability to innovate may be impaired. Innovation needs slackresources, organic and fluid organizational processes, and experimental andentrepreneurial competencies—all attributes that external sourcing does notguarantee.

9. Dangers of an external triangle. Some years ago when IT specialists and userscould not understand each other, a few companies created a new role for interme-diaries or interpreters between the two parties. Often called business analysts,client managers, or systems liaison officers, they sought in theory to understanduser needs and convey them to the specialists, while representing the specialists’concerns to the users. Similarly after outsourcing, the remaining IT people may actas conduits or consultants between the line managers and the vendors. In practice,the liaison roles often only succeed in keeping two communities apart and increating more confusion.

10. Technological indivisibility. Much of IT is not divisible or capable of separation.Current IS are increasingly integrated or interconnected, and problems can occurat the interface of responsibility between different vendors or between thevendor’s domains and the customer’s domain.

11. Fuzzy focus. Outsourcing is essentially concerned with the supply side of IT. Themarketplace in principle can provide IT operations, development, service, andtraining. It is not so able to provide acceptable, innovative application ideas, thechallenging effort and commitment required in systems implementation, and theharvesting and delivery of IT benefits. A real problem, then, with outsourcing isthat it concentrates on the how of IT, not on the what. It focuses on the supply side,not the demand side. And because it occupies substantial management resourcesand executive time, it can unwittingly become another form of denominatormanagement rather than revenue creation—not a prescription for long-term suc-cess.

Also Bahli and Rivard (2003) identified IT outsourcing risks. They define risks as factorsthat influence the occurrence of undesirable outcomes. The degree to which each factoris present in IT outsourcing will contribute to the increased likelihood of a given outcome.Once this list of factors is drawn, risk management methods will consist of devising andusing mechanisms that will either diminish the loss related to the outcome or decreasethe likelihood of its occurrence by reducing the level of the risk factors. Four undesirableoutcomes can be identified in IT outsourcing, and associated risk factors and conse-quences can be defined as follows:

• Lock-in is an undesirable outcome based on risk factors such as high assetspecificity, small number of suppliers, and the client’s low degree of expertise inoutsourcing contracts. Consequences are cost escalation and service debasement.Suggested mitigation mechanisms are mutual hostaging and dual sourcing.

• Costly contractual amendments are an undesirable outcome based on risk factorssuch as high uncertainty and unanticipated changes. Consequences are cost



escalation and service debasement. Suggested mitigation mechanisms are sequen-tial contracting and contract flexibility.

• Unexpected transition and management costs is an undesirable outcome based onrisk factors such as high uncertainty, the client’s low degree of expertise in IToperations, and the client’s low degree of expertise in outsourcing contracts.Consequences are cost escalation and service debasement. Suggested mitigationmechanisms are clan mechanisms and use of external expertise.

• Disputes and litigation is an undesirable outcome based on risk factors such asmeasurement problems, the supplier’s degree of expertise in IT operations, and thesupplier’s degree of expertise in outsourcing contracts. Consequences are costescalation and service debasement. Suggested mitigation mechanisms are alterna-tive methods of dispute resolution, clan mechanisms, and use of external expertise.

As global outsourcing or offshoring arises, companies must also be aware of the pitfallsof migrating business process overseas to India, the Philippines, Ireland, China, andelsewhere to lower their costs. Meta Group reports offshoring saves 20% in the first year,and creates a 20% loss in productivity. In other words, actual savings are oftentimesmisperceived. Other offshoring pitfalls to consider are security, scope creep, culture, andknowledge transfer. Risks are raised when working internationally and companies mustaddress privacy concerns. Many projects grow during the development cycle. Scoopcreep is not only a phenomenon of offshoring, but it might also increase as language andcultural differences increase. Differences in customs must be taken into account, as thedifferences are often more significant than anticipated. Time and effort to educate andtrain the vendor is a cost rarely accounted for by the IT client organization (InfoWorld,2004).

Business Example: NetCom

“Nobody is good at everything,” says IT department manager Bjørn Tore Gullord. WhenNetCom outsourced large parts of its Intel-based operations, it acknowledged, “Othersare better at this!”NetCom chose Ementor as outsourcing partner the winter of 2003. “For several yearsEmentor had delivered outsourcing services to NetCom, and we had good experienceswith them. They had built credibility and trust, which assured us they would be capableof handling an expanded range of our services,” continues Gullord.Different outsourcing approaches are being used. Within the areas of Unix and “billing,”they use on-site services as a supplement to internal resources. Service desk, on-sitesupport of clients and management of the telephony solution, everything is outsourcedto Ementor, as well as monitoring and management of large parts of the Intel-servers.“What we have gained is better cost control, greater flexibility when it comes to NetCom’s



development, and better quality. None is good in everything—IT operation is better doneby others,” claims Gullord.The contract runs for three years and encompasses operations of large parts of Netcom’sICT platform: e-mail, file, print, applications, hardware, user support, backup, and allclients totalling 800 users. In addition, Ementor operates Netcom’s call center solutionCIC. The outsourcing agreement supports all of NetCom, including customer supportcenters in Oslo, Trondheim, and regional offices.“We’re proud of this prestigious agreement that has substantial requirements on service-period [uptime] and quality,” says Ementor Operations Director Tore Haugeland.NetCom has an SLA agreement with 99.5% uptime for the terminal server solution, and99.9% uptime for the call enter solution. “NetCom’s choice of working with Ementorproves our competitive outsourcing services, and our capability of handling large andcomplex outsourcing agreements. This partnership strengthens Ementor’s ambitions ofstrong growth and domination in this market,” continues Haugeland.NetCom is the second largest mobile phone operator in Norway, and the Norwegian partof TeliaSonera. The company offers mobile telecommunication solutions in Norway, andis an innovative company known for its creativity and focus on customer needs.NetCom’s head office is placed in Oslo, with branch offices in Trondheim, Bergen,Stavanger, Kristiansand, and Tønsberg. Total number of employees is approximately740. (Source: Pieter Spilling, Ementor, e-mail May 21, 2004).

Business Example: DuPont

Three thousand one hundred persons transferred from DuPont to Computer SciencesCorporation (CSC) and Andersen Consulting (AC) after signing of the outsourcingcontract in 1997. DuPont retained 1,200 IT people, 100 people in centralized businesscenter, and 1,100 people in the strategic business units with business and technicalresponsibility.One reason for IT outsourcing was skill renewal. DuPont wanted access to supplier ITskills, including state-of-the-art business solutions, methods, and technologies. At thesame time, DuPont wanted greater professional development and career advancementopportunities for the IT workforce. After outsourcing, the ex-DuPont staff had success-fully transitioned, but now DuPont wonders if it gave away too much expertise. DuPontwas a little behind in its expectation about how many technical resources it would needon an ongoing basis. It thought that it could pretty much deplete itself of a lot of thatand its partners would handle all that kind of work for it. However, DuPont realized thatthe company itself had to make technical decisions and the partners did not have the samedegree of intensity of DuPont’s interests at heart.Several years into the contract, DuPont swapped employees by giving 300 decentralizedIS analysts to one supplier in exchange for bringing some contract facilitator/managersback in-house. It is not uncommon for customers to face serious difficulties in assessinga priori, which staff should be retained and which staff should be transferred. (Source:Lacity & Willcocks, 2001).



Case Study:The Largest Buy-Out in Europe

Computer Science Corporation (CSC) has, by December 18, 2003, acquired ScandinavianIT Group (SIG). SIG was own by the SAS Group and had previously been legallyindependent as a stand-alone company for years. This meant that there was already agood basis available for outsourcing in the form of extensively documented agreementsfor services between SAS and SIG, and this laid the foundation for a rapid straightforwardconclusion of a new agreement with CSC.The SAS Group serves northern Europe with air travel and airline-related businesses.SAS’s parent companies were founded in Denmark (1918), Sweden (1924), and Norway(1927). Scandinavian Airlines System was founded on August 1, 1946, to coordinateflights from Scandinavia to the United States. It has more than half a century of aviationexperience. SAS airline companies fly to more than 80 major destinations in Scandinaviaand Europe. In addition, there are also flights to the United States and Asia. Throughpartnership in the Star Alliance, the SAS Group can offer a worldwide network coveringa total of 673 airports in 127 countries. Today, the SAS Group is Europe’s fourth-largestairline group, carrying more than 31 million passengers in 2003. The SAS Group’s 2003revenue was MSEK 58,000. Employing more than 33,000 people in five business areas—Scandinavian Airlines, subsidiary and affiliated airlines, airline support businesses,airline-related businesses, and hotels (Scandinavian Airlines System, 2004a, 2004b).SAS uses a broad range of applications—for customers, travel agencies, and reservationoffices, and also for crew planning and aircraft maintenance and repair. Throughout theyears SAS has been an early mover by doing its own development and implementationof mission-critical business applications. Nowadays, there are standard applicationsavailable in the marketplace satisfying the needs of an airliner.SAS started a huge cost-reduction program called “Turn Around 2005” due to the stateof the airline market after September 11, 2001. The group looked at all kinds of costs,including IT costs. The goal was to reduce IT costs significantly within a few years, partlyby reducing costs directly and partly by exchanging old legacy systems with newstandardized ones. SIG was sold out of airline-related business during the fourth quarterof 2003, and the SAS Group entered into an IT outsourcing agreement with CSC. Underthe terms of the contract, CSC provides IT consulting, systems integration, applicationdevelopment and maintenance, and IT infrastructure services for mission-critical SASbusiness needs, including booking and ticket reservation systems, ticket-free traveltechnologies, self-service check-in, flight maintenance, and cargo control systems. AllSAS destination airports are included in the services of the outsourcing deal, as they werepreviously serviced by SIG.

IT Outsourcing Theories 71


Chapter IV

IT OutsourcingTheories

Based on outsourcing definitions explored in Chapter II, we can identify taxonomies, orschools of IT outsourcing. The primary purpose of this framework is to guide executiveson choice to initiate outsourcing projects according to goals, organizational character,and technological, behavioral, or economic biases. This approach is adapted from Earl(2001).Each school is proposed as an ideal type based on theory. No claims are made that anyone school outperforms others. Each represents a particular theoretical orientation anda different form of organizational intervention at IT outsourcing. The schools are notmutually exclusive. Indeed, two or more of them sometimes can be observed in the sameoutsourcing arrangement. Furthermore, there may be other schools that our literaturereview has not encountered. We identified the following theory-based schools in IToutsourcing: the transaction cost school, the school of neoclassical economics, thecontractual school, the school of core competencies, the agency school, the resource-based school, the school of partnership and alliance, the relational exchange school, thestakeholder school, the school of firm boundaries, and the school of social exchange.Each of these 11 schools are presented in this chapter and compared at the end of thechapter.

Transaction Cost Theory

In his seminal paper, Coase (1937) identifies transaction costs as the primary determinantof the boundaries of the firm. Ideally, contracts between buyers and sellers provideadaptation strategies for all possible contingencies. However, this requires eithercertainty regarding the future economic environment or unbounded rational reasoning



(knowing all possible future states). Transaction costs arise because complete contract-ing is often impossible, and incomplete contracts give rise to subsequent renegotiationswhen the balance of power between the transacting parties shifts (Williamson, 1979).Transaction costs include the costs associated with writing contracts as well as the costsof opportunistic holdup at a later date. Although internal organization or hierarchies areposited to offer lower costs of coordination and control and to avert subsequentopportunistic behavior, related problems can occur in decentralized firms. A majorconcern is the loss of high-powered incentives when the pay-for-performance link isattenuated by internal production (Anderson, Glenn, & Sedatole, 2000).Firms are hypothesized to choose organizational boundaries to minimize the sum ofproduction and transaction cost (Williamson, 1979). Five attributes of business ex-change are positively associated with transaction costs: (1) the necessity of investmentsin durable, specific assets; (2) infrequency of transacting; (3) task complexity anduncertainty; (4) difficulty in measuring task performance; and (5) interdependencies withother transactions. The necessity of early investments in durable, transactions-specificassets (e.g., human and physical capital) shifts the balance of power between transactionparticipants, because in later renegotiations these costs are sunk costs of the party thatincurs them. Infrequent transactions increase the likelihood of opportunistic behaviorin later periods by reducing the threat of retribution. In situations where broader marketreputations are at stake, infrequent transactions may be sustainable. However, evenlong-term contracts often do not provide sufficient adaptation mechanisms, and inflex-ibility may actually induce holdup. Task complexity, uncertainty, and measurementproblems exacerbate the problem of identifying and contracting for contingencies.Interdependencies introduce contingencies among transactions that suggest co-loca-tion (e.g., system-level sourcing) or that require high-level coordination (Anderson etal., 2000).The five transaction attributes indicate settings in which opportunistic behavior is likely.If transactions costs offset production cost advantages of the external supplier, the firmsubsumes the activity—an outcome termed vertical integration or insourcing. Empiricalresearch indirectly tests transaction cost theory by relating observed sourcing decisionsto transaction attributes that proxy for transaction costs. Evidence on the relationbetween transaction-specific investments, contract duration, and technological uncer-tainty generally supports the theory. The consistency of the empirical results seemsstartling in light of two problems with the hypothesis that firms take sourcing decisionsto minimize the sum of production and transaction costs. First, production and transac-tion costs are rarely neatly separable. For example, the choice of production technology(and subsequent production costs) is often inextricably linked with production volume,which in turn depends on whether the firm produces some or all products internally.Second, decision makers are likely to be affected by wealth effects associated withsourcing, and thus are unlikely to take decisions that strictly maximize firm profit(Anderson et al., 2000).Because production costs are objectively calculated by the accounting system, whiletransaction costs are assessed subjectively through indirect indicators, functionalmanagers are likely to differ in the importance that they assign to reducing transactioncosts. Consequently, the effect transaction costs have on a make-or-buy choice canpartly reflect the influence exerted by the purchasing manager. Production cost differ-



ences seems more influential in sourcing decisions than transaction cost differences, andexperience of the decision maker is related to assessments of technological uncertainty.Profit center managers engage in influence activities that increase the costs of pricerenegotiations above the level that is observed in comparable external market transac-tions. Managers sometimes seem more reluctant to outsource when investments inspecific assets are necessary; and contrary to theory, managers sometimes considerprevious internal investments in specific assets a reason to insource. In certain circum-stances decision makers systematically misestimate (or fail to consider) transactioncosts (Anderson et al., 2000).Firms are turning in increasing number to strategic alliances to help them compete. Yeta number of researchers argue that the costs of coordinating activities outweigh thebenefits that these alliances can provide. A crucial question to be addresses then is“What are the factors that determine these coordination costs?” Artz and Brush (2000)examined supplier relationships that were governed by relational contracts, and theyfound support for the transaction cost theory. Asset specificity and environmentaluncertainty directly increased coordination costs.In transaction cost economics, an organization chooses to source via its own hierarchyor via the market, based on relative cost, which has two components: production costsand coordination (transaction) costs. Economies of scale, via the market, can reduceproduction costs. Transaction costs are determined by several factors: asset specificity,transaction frequency and uncertainty. Asset specificity is the degree to which an assetcan be redeployed to alternative uses and by alternative users without sacrifice ofproductive value (Hancox & Hackney, 2000).Williamson (1979) identified three types of transaction according to specificity. Nonspe-cific transactions have low asset specificity and are associated with the acquisition ofcommodities. Idiosyncratic transactions have high specificity. Mixed transactions haveelements of both commodity and customization. Transaction specificity can be viewedalongside transaction frequency, a second major construct of transaction cost econom-ics, which distinguishes occasional from recurrent transactions. Two frequency catego-ries multiplied by three specificity types produce six discrete transaction types. It canbe argued that the market is better for all but transactions, which are both recurrent andidiosyncratic. The third major determinant of transaction costs is uncertainty, com-pounded by the bounded rationality of humans and often associated with the complexityof the product to be acquired. Rather than developing specialized client-specificproducts, vendors may find it cheaper and safer to provide a standard product, whereasorganizations may prefer to acquire complex products via the internal hierarchy ratherthan the market. Throughout market usage, there is also the danger of opportunism—lackof candor or honesty in transactions (Hancox & Hackney, 2000).Opportunism is self-interest seeking with guile and includes overt behaviors such aslying, cheating, and stealing, as well as subtle behaviors such as dishonoring an implicitcontract, shirking, and failing to fulfill promises and obligations. It is the equivalent ofbad faith, the implication being that the party who is opportunistic is not trustworthy.In an outsourcing setting, opportunism may involve misrepresentations, unresponsive-ness, unreasonable demands, and lying. The notion of opportunism is what differentiatestransaction cost theory from alternative conceptualizations of the firm, such as agencytheory, relational exchange theory, or resource-based view. The transaction cost



economics presumption is that economic actors attempt to forecast the potential foropportunism as a function of unfolding circumstances, then take preventive actions intransactions where opportunism is likely to be high. Opportunism is an explanatorymechanism, not readily observable, and typically empirically untested. However, it isimportant because it has potential for enormous impact on economic performance (Jap,2001).Opportunism is likely to increase if there are only a small number of vendors as only afew are able and willing to contract. Transaction costs appear to be difficult to avoid andmay be unavoidably greater in some settings than in others. For example, it can be arguedthat in the public sector contract creation and monitoring are more difficult because ofthe sector’s complexity and because there are costs associated with bureaucracy anddemocracy which are hard to allocate to specific functions (Hancox & Hackney, 2000).Several authors have been able to relate transaction cost economics to IT. For example,asset specificity has been found in IT. Transaction frequency in IT terms can beillustrated by, for example, contrasting the recurrent nature of processing a payroll everymonth with the occasional (indeed, unique) nature of a bespoke systems developmentproject. Uncertainty is found in many aspects of IT and is particularly associated withsystems development and unpredictable business and technological change. Thedifficulties and costs of both market usage and provision via the hierarchy perhapsexplain why extremes of vertical integration and spot market transactions in IT arecomparatively rare, resulting in a range of sourcing options.IT transaction costs may be reduced by various methods. For example, using severalvendors can reduce the damage caused by one bad contract, but this may increasecomplexity or may be impossible because of a dearth of bidders. Also, outsourcing aslittle as possible would be expected to minimize transaction costs, and various authorssuggest ways to improve in-house performance. Often, the possibility of improvementis ignored.Hancox and Hackney (2000) interviewed IT managers to find support for the transactioncost theory in IT outsourcing. Many of the features of transaction cost economics couldbe identified in the outsourcing arrangements. For example, there was high site specificityand low site specificity, with a common preference for using packaged off-the-shelfproducts rather than systems developed in-house. Human specificity related to the typeof skills sought from a vendor, with most being unconcerned with vendor knowledge ofapplications and business. Dedicated investment asset specificity was shown by someclients’ insistence that vendors made the commitment of accepting the transfer ofemployees. Transaction types could be identified, with nonspecific transactions suchas day-to-day running of infrastructural elements such as computer operations and PCsupport tending to be outsourced early on. There was also concern about the smallnumber of vendors in the market. In these circumstances, through the absence of viablealternatives, clients relied increasingly upon trust and experience when dealing withvendors.Transaction cost economics has emerged as a common framework for understanding howmanagers craft governance arrangements. The general proposition of this literature isthat managers align the governance features of interorganizational relationships tomatch known exchange hazards, particularly those associated with specialized asset



investments, difficult performance measurement, or uncertainty. In response to ex-change hazards, managers may craft complex contracts that define remedies for foresee-able contingencies or specify processes for resolving unforeseeable outcomes. Whensuch contracts are too costly to craft and enforce, managers may choose to verticallyintegrate. Many have argued, however, that transaction cost economics overstates thedesirability of either integration or contractual safeguards in exchange settings com-monly labeled as hazardous. This view recognizes that in many industries managersengage in complex, collaborative market exchanges that involve rather high levels ofasset specificity and that are characterized by other known hazards. Cooperation andrelational governance are often viewed in this literature as substitutes for complex,explicit contracts or vertical integration (Poppo & Zenger, 2002).According to Henisz and Williamson (1999), transaction cost economics is a comparativecontractual approach to economic organization in which the action resides in the detailsof transactions on the one hand and governance on the other. Given that all complexcontracts are unavoidably incomplete (by reason of bounded rationality) and thatcontract as mere promise, unsupported by credible commitments, is not self-enforcing(by reason of opportunism), the question is which transactions should be organized how.Much of the predictive content of transaction cost economics works through thediscriminating alignment hypothesis, according to which transactions, which differ intheir attributes, are aligned with governance structures, which differ in their costs andcompetencies, so as to effect a (mainly) transaction cost economizing result. Implement-ing this requires that transactions, governance structures, and transaction cost econo-mizing all be described.Transaction cost economics concurs that the transaction is the basic unit of analysis andregards governance as the means by which order is accomplished in a relation in whichpotential conflict threatens to undo or upset opportunities to realize mutual gains (Henisz& Williamson, 1999). The problem of conflict on which transaction cost economicsoriginally focused is that of bilateral dependency. The organization of transactions thatare supported by generic investments is easy: classical market contracting works wellbecause each party can go its own way with minimal cost to the other. Specificinvestments are where the problems arise. Contracts that are supported by durableinvestments in nonredeployable assets pose contractual hazards, in that one or bothparties can defect from the letter of spirit of an agreement. That is true even if propertyrights are well defined, contract laws are well conceived, and the judiciary enforces thelaws in a principled way. Thus, even if property rights are well defined in general, someproperty rights are very hard to describe (it is not cost effective to describe them withgreater precision) and hard to enforce (it is difficult for a court to be apprised of trueunderlying conditions). Property rights ambiguities thus remain even in a regime wherebest efforts to define and enforce property rights through the courts have been made.Similar considerations apply to contract law: there are limits on how exacting the law canbe and how effectively the courts can enforce the law.The upshot is that a huge amount of property right protection and contract lawenforcement is moved out of the courts and onto private ordering. In many instances,the participants can devise more satisfactory solutions to their disputes than canprofessionals constrained to apply general rules on the basis of limited knowledge of thedispute. The courts are thus reserved for purposes of ultimate appeal. The alignment of



transactions to alternative modes of private ordering—principally markets, hybrids, andhierarchies—is where the main action resides. Taking adaptation (of autonomous andcooperative kinds) to be the central problem of economic organization, the basicalignment is that simple transactions (by which we mean those that pose few contractualhazards) will be organized in markets and that transactions thereafter move to hybridsand, eventually, to unified ownership (hierarchy) as contractual hazards build up. Whencontractual hazards are low, more complex forms of organization are at a disadvantagesince they incur added bureaucratic costs for which no benefits can be ascribed.However, as contractual hazards increase, the high-powered incentives of the marketimpede adaptability and maladaptation costs are incurred. Although the transfer of suchtransactions from market to hierarchy creates added bureaucratic costs, those costs maybe more than offset by the bilateral adaptive gains that result (Henisz & Williamson,1999).Transaction cost economics is located on the branch of the new institutional economicsthat is mainly concerned with governance. The new institutional economics argues thatinstitutions are both important and susceptible to analysis. It is based on the assumptionthat human actors have limited cognitive competence—often referred to as boundedrationality. Given such cognitive limits, complex contracts such as IT outsourcingcontracts are unavoidably incomplete. Contractual incompleteness poses problemswhen paired with the condition of opportunism, which manifests itself as adverseselection, moral hazard, shirking, subgoal pursuit, and other forms of strategic behavior.Because human actors will not reliably disclose true conditions upon request or self-fulfill all promises, contract as mere promise, unsupported by credible commitments, willnot be self-enforcing (Williamson, 2000).Saarinen and Vepsäläinen (1994) applied transaction cost economics to procurementstrategies for IS. Procurement means the choice among suppliers (in-house personnel,outside experts, consultants, software contractors, or package dealers) and contractingforms (salary, project contract, package price, lease, or rent) for acquiring an asset. Inapplying transaction cost economics to the procurement methods of IS, Saarinen andVepsäläinen first identified the most important characteristics of the desired transactions(IS projects) and alternative governance structures (project organization) in order to findthe effective strategies. They conclude that systems that are company-specific andinvolve high uncertainty have to be internally developed because they require both thespecific knowledge and intensive interaction between developers and users. Morestandard requirements indicate the use of outside consultants or software contractorwho have experience and knowledge about a similar type of systems. For routine systemscommon in many organizations, acquisition and tailoring of a software package providesthe most efficient procurement strategy.Transaction cost economics describes the firm not in technological terms (as a produc-tion function) but in organizational terms (as a governance structure). Firm and marketare alternative modes of governance that differ in discrete structural ways. Chief amongthe attributes that describe a mode of governance are (1) incentive intensity, (2)administrative controls, and (3) the legal rules regime. These in turn give rise todifferential adaptive capacity—in both autonomous and cooperative adaptation re-spects. Alternative modes of governance are internally consistent syndromes of theseattributes, which is to say each has distinctive strengths and weaknesses (Williamson,1999).



Neoclassical Economic Theory

Neoclassical economic theory posits that firms outsource IT to attain cost advantagesfrom assumed economies of scale and scope possessed by vendors (Ang & Straub, 1998).This theory attained more empirical support in studies of outsourcing decisions thantransaction cost economics. Neoclassical economic theory regards every businessorganization as a production function (Williamson, 1981), and where their motivation isdriven by profit maximization. This means that companies offer products and services themarket where they have a cost or production advantage. They rely on the marketplacewhere they have disadvantages. According to neoclassical economic theory, companieswill justify their sourcing strategy based on evaluating possibilities for production costsavings. Thus, the question of whether to outsource, is a question whether themarketplace can produce products and services at a lower price than internal production.In the context of IT outsourcing, a company will keep its IT-function internally if this hasproduction cost advantages, and it will outsource when the marketplace can offerproduction cost savings.However, defining outsourcing simply in terms of procurement activities does notcapture the true strategic nature of the issues (Gilley & Rasheed, 2000). IT outsourcingis not only a purchasing decision—all firms purchase elements of their operations. Thisis done to achieve economic, technological, and strategic advantages. However, theeconomies of scale and scope argument would predict that outsourcing has little to offerto larger firms, because they can generate economies of scale and scope internally byreproducing methods used by vendors. As documented by Levina and Ross (2003), thereare other reasons for large firms to move into outsourcing.In neoclassical economic theory, outsourcing may arise in two ways. First, outsourcingmay arise through the substitution of external purchases for internal activities. In thisway, it can be viewed as a discontinuation of internal production (whether it beproduction of goods or services) and an initiation of procurement from outside suppliers.To the extent this type of outsourcing reduces a firm’s involvement in successive stagesof production, substitution-based outsourcing may be viewed as vertical disintegration.This seems to be the most commonly understood type of outsourcing. Outsourcing mayalso occur through abstention. Outsourcing need not be limited to those activities thatare shifted to external suppliers. On the contrary, outsourcing may also arise when a firmpurchases goods or services from outside organizations even when those goods orservices have not been completed in-house in the past. In neoclassical economic terms,Gilley and Rasheed (2000) posed the question, “Making more by doing less?” Their studyempirically examined the extent to which outsourcing of both peripheral and near-coretasks influenced firms’ financial and nonfinancial performance. In addition, the potentialmoderating effects of firm strategy and the environment on the outsourcing–perfor-mance relationship were examined. Results indicate that, whereas there was no signifi-cant direct effect of outsourcing on firm performance, both firm strategy and environmen-tal dynamism moderated the relationship between outsourcing and performance.In neoclassical economic theory, both the distribution of income and the compositionof output are endogenously and simultaneously determined by a general equilibrium ofsupply and demand. The underlying data on the supply side are parametrically given



resource inputs and a given technology of production for transforming inputs intooutputs; on the demand side, the data are specified in terms of a given distribution ofownership of inputs and a given pattern of preferences for final outputs (Gram, 2003). Adistinction is also made between the representative firm and the equilibrium firm. Therepresentative firm is representative of an industry in the sense that it has normal accessto the economies—external and internal, which belongs to the aggregate volume ofproduction. It is the expenses of the representative firm that is used when the normalsupply schedule of an industry is being derived (Hart, 2002).

Contractual Theory

Luo (2002) examined how contract, cooperation, and performance are associated witheach another. He argues that contract and cooperation are not substitutes but comple-ments in relation to performance. Contracting and cooperation are two central issues inan IT outsourcing arrangement. A contract alone is insufficient to guide outsourcingevolution and performance. Since outsourcing involves repeated interorganizationalexchanges that become socially embedded over time, cooperation is an importantsafeguard mechanism mitigating external and internal hazards and overcoming adaptivelimits of contracts. The simultaneous use of both contractual and cooperative mecha-nisms is particularly critical to outsourcing arrangements in an uncertain environment.An outsourcing contract provides a legally bound, institutional framework in which eachparty’s rights, duties, and responsibilities are codified and the goals, policies, andstrategies underlying the arrangement are specified. Every outsourcing contract has thepurpose of facilitating exchange and preventing opportunism. Appropriate contractualarrangements can attenuate the leeway for opportunism, prohibit moral hazards in acooperative relationship, and protect each party’s proprietary knowledge. A completecontract reduces the uncertainty faced by organizational decision makers and the risksstemming from opportunism on the part of one or more contracting parties. It providesa safeguard against ex post performance problems by restraining each party’s ability topursue private goals at the expense of common benefits. An incomplete contract maybring about ambiguity, which creates a breeding ground for shirking responsibility andshifting blame, raises the likelihood of conflict, and hinders the ability to coordinateactivities, utilize resources, and implement strategies.Contractual completeness is not just term specificity (i.e., the extent to which all relevantterms and clauses are specified), nor should every outsourcing contract maintain thesame level of completeness. Previous studies that view contractual completeness andterm specificity as equivalent have created a controversy about the role of the contract.For instance, it has been suggested that incomplete contracts are optimal in situationswhere some elements of enforcement are unverifiable. Similarly, it has been argued thateconomic agents rarely write contracts that are complete because bounded rationalparties may not be able to distinguish certain contingencies. By contrast, othersdemonstrate that contractual completeness reduces role conflict and role ambiguity foroutsourcing managers, which then enhances outsourcing performance. Furthermore, it



has been suggested that term specificity protects a partner’s strategic resources andreduces operational and financial uncertainties through controlling opportunism andspurring information flow within an outsourcing arrangement.Luo (2002) suggests that contract completeness is a multidimensional concept, includingnot only term specificity but also contingency adaptability. Outsourcing contracts arerelational contracts characterized by long durations of interpartner dependency andenormous unanticipated contingencies in an uncertain environment. Outsourcing ofteninvolves highly idiosyncratic assets that give rise to high coordination costs andappropriation concerns. The optimal contract completeness simultaneously requiresopportunism mitigation and adaptation promotion. Luo argues that bounded rationality,asymmetrical information, and enforceability costs under an unpredictable environmentfurther propel the need for contractual adaptation. According to Williamson (1979), anyrelational contract seeking the maximum payoff must delineate both the substance andstructure of the exchange. In order to describe exchange substance, detailed specifica-tions of contractual terms are required. To delineate exchange structure, contingencyadaptability must be included because this structure concerns how reciprocal depen-dency and outsourcing arrangement adaptation proceed within the total period of anexchange.According to Luo (2002), contingency adaptability is the extent to which unanticipatedcontingencies are accounted for and relevant guidelines for handling these contingen-cies are delineated in an outsourcing contract. In contracts, contingency adaptabilityoften describes a mutually agreed tolerance zone or excuse doctrine for dealing withunexpected events, or stipulates principles, guidelines, and possible solutions fordealing with conflicts and contingencies. In practice, these guidelines or possiblesolutions are incorporated in a contract as either independent terms (e.g., procedures forhandling important contingencies; guidelines in case of doubt or hazards; approachesfor overcoming conflict and handling force majeure) or as a part of related clauses inspecific areas (e.g., how to handle unanticipated changes in the market, governmentalpolicies, technological changes, software license agreements, mergers and acquisi-tions). While term specificity concerns how specific and detailed the terms are, contin-gency adaptability involves how to contractually respond to future problems, conflicts,and contingencies. These two dimensions, each capturing different aspects of complete-ness, may reach high levels when an outsourcing arrangement operates in a promisingbut volatile environment.Poppo and Zenger (2002) have studied formal contracts and relational governancefunction as substitutes or complements. Formal contracts represent promises or obliga-tions to perform particular actions in the future. The more complex is the contract, thegreater is the specification of promises, obligations, and processes for dispute resolu-tion. For example, complex contracts may detail roles and responsibilities to be performed,specify procedures for monitoring and penalties for noncompliance, and most impor-tantly, determine outcomes or outputs to be delivered. According to the logic oftransaction cost economics, the manager’s task is to craft governance arrangements withminimal cost that ensure the delivery of the desired quantity, price, and quality of asupplier’s services. The manager, therefore, crafts governance arrangements to matchthe exchange conditions that accompany various services. As exchange hazards rise somust contractual safeguards, which act to minimize the costs and performance losses



arising from such hazards. Because crafting a complex contract is costly, partiesundertake such a cost only when the consequences of a contractual breach areconsiderable.Transaction cost economics scholars commonly point to three categories of exchangehazards that necessitate contractual safeguards (or vertical integration): asset specific-ity, measurement difficulty, and uncertainty. Asset specificity emerges when sourcingrelationships require significant relationship-specific investments in physical and/orhuman assets. The presence of these specific assets transform an exchange from a worldof classical contracting into a world of neoclassical contracting in which the identity ofparties is irrelevant into a world of neoclassical contracting in which the identity ofexchange partners is of critical importance. For example, an IT outsourcing provider mayneed to customize service offerings to the clients work setting. Similarly, the client mayneed to develop a unique understanding of the provider’s procedures, approach, andlanguage to effectively utilize their services.Difficulty in measuring the performance of exchange partners also generates markethazards. Markets succeed when they can effectively link rewards to productivity—thatis, they can measure productivity and pay for it accordingly. Uncertainty, a third hazard,also challenges an exchange by requiring the parties to adapt to problems raised fromunforeseeable changes. High levels of uncertainty in conjunction with measurementdifficulty or asset specificity render contracting even more hazardous. This encouragesmore complex contracts (Poppo & Zenger, 2002).However, a contract alone is insufficient to guide outsourcing arrangements. Coopera-tion is also needed. Cooperation is an improvement process through mutual forbearancein the allocation of resources, such that one party is made better off and no one is worseoff than it would otherwise be. Cooperation is a necessary complement that overcomeslong-term contracts’ constraints in adaptation and execution and becomes an importantvehicle that nourishes continuity and flexibility when change and conflict arise (Lou,2002). Similar to Luo’s argument that contract and cooperation are not substitutes butcomplements, Poppo and Zenger (2002) argue that contracts and relational governanceare not substitutes but complements. They found that relational exchange arrangementssupported by trust are commonly viewed as substitutes for complex contracts ininterorganizational exchange, and that many argue that formal contracts actually under-mine trust and thereby encourage the opportunistic behavior they are designed todiscourage.In their research, Poppo and Zenger (2002) developed and tested the perspective thatformal contracts and relational governance function as complements. Using data froma sample of information service exchanges, they found empirical support for thisproposition of complementarity. Managers appear to couple their increasingly custom-ized contracts with high levels of relational governance (and vice versa). Moreover, thisinterdependence underlies their ability to generate improvements in exchange perfor-mance.Many scholars, including transaction cost economists, have observed that the gover-nance of interorganizational exchanges involves more than formal contracts.Interorganizational exchanges are typically repeated exchanges embedded in socialrelationships. Governance emerges from the values and agreed-upon processes found



in social relationships, which may minimize transaction costs as compared to formalcontracts. For such relationally governed exchanges, the enforcement of obligations,promises, and expectations occurs through social processes that promote norms offlexibility, solidarity, and information exchange. Flexibility facilitates adaptation tounforeseeable events. Solidarity promotes a bilateral approach to problem solving,creating a commitment to joint action through mutual adjustment. Information sharingfacilitates problem solving and adaptation because parties are willing to share privateinformation with one another, including short-term and long-term plans and goals. Asthe parties commit to such norms, mutuality and cooperation characterize the resultantbehavior (Poppo & Zenger, 2002).Kern and Willcocks (2000) have investigated contracts in IT outsourcing. The contractin outsourcing has been described as a mechanism that establishes the balance of powerbetween the client and vendor. Contracts essentially have to be as airtight as possible,because research has shown that vendors tend to refer to it as their chief source ofobligation. Vendors however would prefer to see the contract as a working document,giving them flexibility to suggest improvements and new services. This is the interest ofmost vendor companies, for their goal is one of profit margins. An IT outsourcingcontract tends to be more complicated than other business contracts, resembling as itdoes a hybrid between an asset purchase and sale agreement, and a sale/leasebackagreement, in that there is a sale of assets or transfer of operations, transfer of employees,and a lease back to the customer of the information technology services that weredivested. This legal complexity is evident in the detail and in the time typically investedin negotiating agreement. Third-party legal experts have for quite some time emphasizedthe need for a comprehensive contract, not only because it is their livelihood, but alsobecause it basically becomes a reference point specifying how the client and vendorrelate. Table 4.1 summarizes the main clauses of an outsourcing agreement as specifiedby legal experts.The outsourcing contract is unlike other service contracts because of the nature of whatis being contracted for and the length of the contracts. This makes it extremely difficultto presentiate service provision or any other exchanges that may be needed in the future.Outsourcing contracts, and indeed most long-term contracts, have a tendency to beincomplete, which raises the possibility of opportunistic behavior by the vendor. It hasbeen proposed to alleviate the incompleteness and presentation situation through arelational, as opposed to a transactional, contract. However, there is evidence that mosteffective outsourcing contracts are essentially neither completely transactional norrelational but mainly transactional intertwined with relational aspects. Actualoperationalization of the written letter of any contract requires procedures that can beprescribed to the relational contract (e.g., extensive cooperation).Kern and Willcocks (2000) focused solely on the transactional aspect of how the contractis enforced, which they identified as determining the control agenda. Control is a complexissue that has received considerable attention in the literature. Some researchers makedistinctions between strategic planning, management control, and operational control.Strategic planning is defined as the process of deciding on the objectives of theorganization, on changing these objectives, on the resources used to attain theseobjectives, and on the policies that are to govern the acquisition, use, and dispositionof these resources. Management control is defined as the process by which management



assures that resources are obtained and used effectively and efficiently in the accom-plishment of organizational objectives, whereas operational control focuses more on theactual efficient and effective performance of activities.Looking at the existing research literature, Kern and Willcocks (2000) identified threecommon dimensions that can be a useful typology for analyzing control in IT: focus ofcontrol (directed at whom or what), measures of control (degree of control), and process

Table 4.1. Essential clauses and issues in IT outsourcing contracts (Kern & Willcocks,2000)

Clauses, i.e., Terms and Conditions Brief Outline 1. Parties and Terms The companies and length of contract 2. Definitions Explanations and definitions in wording 3. Supporting documentation Any documentation clarifying the client’s and ven-

dor’s intentions and objectives, and that can be helpful for dispute resolution (e.g., request for proposal [RFP])

4. Asset transfer Transfer of assets and employees to vendor 5. Base services, i.e., service sup-

ply and testing Description of services to be delivered to the ven-dor

6. Performance standards, i.e., service-level agreement

Description of the service levels vendor is ex-pected to provide

7. Service and equipment loca-tion(s)

The actual physical locations of services and se-curity issues

8. Additional services and projects Any other services or projects the client may need or is considering

9. Service management and con-tract monitoring

Both parties endeavor to achieve the terms stipu-lated in the contract

10. Disaster recovery and security Backup and emergency services and other secu-rity concerns

11. Obligations and responsibilities of the client

Client should make all reasonable efforts to en-sure achievement of the contract

12. Benchmarking Method for monitoring vendor’s performance 13. Vendor personnel Overview of vendor’s key employees for contract 14. Payments Describes the base charges and any additional

charges for services delivered 15. Payment schedule The times of payment for different services deliv-

ered 16. Taxes Explains the tax situation 17. Audits Financial control and monitoring 18. Change control and manage-

ment Provisions to change services and its manage-ment

19. Dispute resolution Procedures for dispute resolution 20. Termination—fees and assis-

tance Reasons for termination, the fees that may arise when client wishes to terminate the contract, and the length of assistance the vendor shall perform

21. Proprietary rights Legal property rights given to the vendor for the length of the contract to deliver services of soft-ware and systems

22. Confidentiality Confidentiality of information and the effects of breach

23. Damages Liquidated damages in the event the vendor fails to meet service levels. Also liability for damages by the client or vendor to the other party when relating to the performance of the contract

24. Miscellaneous provisions Numerous other contractual terms and conditions 25. Appendices Exhibits, i.e., schedules



of control (means of enforcing control). Using this typology as an underlying guide, Kernand Willcocks presented a postcontract management agenda as the focus of control.Their postcontract management agenda is listed below:

1. Setting and/or approving IT strategy, architectural directions, and businessimprovements

2. Ensuring user service objectives and customer satisfaction targets are achieved3. Ensuring quality and continuous improvements4. Setting and changing priorities to ensure objectives of the business are met5. Being the focal point for determination and translation of all new business

requirements necessitating vendor action6. Resolving disputes that arise7. Overseeing the vendor’s performance as specified in the agreement8. Monitoring overall service quality and continuous improvement initiatives9. Assuring proper charges and billing for the services rendered10. General contract administration and amendment control11. Involvement in allocating new managers in vendor company to handle the account

The greatest challenge that client companies face following the signing of the contractis the achievement and the enforcement of agreed terms. A number of stipulated termswill always be integral to driving the outsourcing venture forward for both sides. For themajority of client organizations it can be assumed that they are service levels and costs(i.e., payments), whereas for the vendor it is clearly payment (i.e., profits). This controlagenda defined by the contract is an integral part of postcontract management. Basedon many years of drawing up outsourcing contracts, large law firms have developed proforma precedent contracts. To enforce the contract, the appointed client managers and/or residual IT group are held accountable for the management and delivery of all productsand services related to the outsourcing venture. Related to this task will be the conjointrationalization and implementation of the vendor’s processes for service changes,charges, and general financial and operational management of the contract, as well asapproval of any special projects that may arise. Appointing duties and responsibility inthe postcontract stage is critical, as effective management necessitates continuouscommunication between the responsible persons to ensure services, payments, and extrarequirements are met and conflicts resolved.Based on their sources, Kern and Willcocks (2000) found the postcontract managementagenda for the client to cover the 11 issues detailed above. For the client to accomplishthis management agenda, an effective communication and operations structure has to beestablished in each organization and between both parties. Interfaces might have tooccur at multiple levels. At the most senior levels, there must be links to deal with majorissues of policy and relationship restructuring, while at lower levels, there must bemechanisms for identifying and handling more operational and tactical issues. Both thecustomer and outsourcer might need regular, full-time relationship managers and coor-



dinating groups lower in the organization to deal with narrow operational issues andpotential difficulties. To ensure the various interfacing points on the vendor’s sidematches the client’s operational and management style, they could ensure mutualinvolvement in selecting key vendor personnel.Relational contract theory was created by Macneil (2000), who has been doing relationalcontracts since the mid-1960s, and who by contract means relations among people whohave exchanged, are exchanging, or expect to be exchanging in the future—in otherwords, exchange relations. He finds that experience has shown that the very idea ofcontract as relations in which exchange occurs—rather than as specific transactions,specific agreements, specific promises, specific exchanges, and the like —is extremelydifficult for many people to grasp. Either that, or they simply refuse to accept that contractcan be defined as relations among people in an exchange. Macneil searched for roots tosummarize contract in a useful manner. He tried to distill what he found into a manageablenumber of basic behavioral categories growing out of those roots. Since repeated humanbehavior invariably creates norms, these behavioral categories are also normativecategories. He identified the following 10 common contract behavioral patterns andnorms: (1) role integrity—requiring consistency, involving internal conflict, and beinginherently complex, (2) reciprocity—the principle of getting something back for some-thing given, (3) implementation of planning, (4) effectuation of consent, (5) flexibility, (6)contractual solidarity, (7) the restitution, reliance, and expectation interests (the linkingnorms), (8) creation and restraint of power (the power norm), (9) proprietary of means,and (10) harmonization with the social matrix, that is, with supracontract norms. Rela-tional contract theory postulates that where the 10 common contract norms are inad-equately served, exchange relations of whatever kind will fall apart. Relational contracttheory is based on the following four core propositions (Macneil, 2000):

• Every transaction is embedded in complex relations.• Understanding any transaction requires understanding all essential elements of its

enveloping relations.• Effective analysis of any transaction requires recognition and consideration of all

essential elements of its enveloping relations that might affect the transactionsignificantly.

• Combined contextual analysis of relations and transactions is more efficient andproduces a more complete and sure final product than does commencing withnoncontextual analysis transactions.

The provability of these propositions varies considerably. The first is a virtuallyindisputable observation of universal human intercourse. The last, particularly the claimto greater efficiency, would be difficult if not impossible to prove empirically, eventhough much evidence can be marshaled in its support. Concerning applicability, it isargued that the four propositions apply to any analysis of any contract or any part ofany contract. However, matters pertaining primarily to the substance of contracts can beexcluded from the claims. The focus of the theory is on what might be called the behavioralaspects of contracts, as distinct from their substance.



Williamson (2002a) compared choice and contract. The science of choice is concernedwith studies of human behavior as a relationship between ends and scarce means, whichhave alternative uses. Similarly, the science of contracts, especially thinking comparativecontractually, invites attention to alternative uses. Therefore, the lens of contract is lessa substitute for than a complement to the orthodox economic lens of choice. Contractsare incomplete (by reason of bounded rationality), they are mere promises that are notself-enforcing (by reason of opportunism), court ordering is limited (by reason ofnonverifiability), and the parties are bilaterally dependent (by reason of transaction-specific investments) and there is also a serious disjunction. Specifically, whereastransaction-cost economics locates the main analytical action in the ex post implemen-tation stage of contract (where inefficiencies due to maladaptation arise), others assumeaway ex post maladoption (by invoking common knowledge of payoffs and costlessbargaining), thereby to focus instead on how different configurations of physical assetownership (to which residual rights of control accrue) are responsible for efficiencydifferences at the ex ante stage of conflict.According to Williamson (2003), the lens of contract approach to the study of economicorganization is partly complementary but also partly rival to the orthodox lens of choice.Specifically, whereas the latter focuses on simple market exchange, the lens of contractis predominantly concerned with the complex contracts. Among the major differences isthat nonstandard and unfamiliar contractual practices and organizational structures thatorthodoxy interprets as manifestations of monopoly are often perceived to serveeconomizing purposes under the lens of contract.The contract law of (ideal) markets is that of classical contracting, according to whichdisputes are costless and settled through courts by the award of money damages.However, many disputes between firms that under current rules could be brought to acourt are resolved instead by avoidance, self-help, and the like. That is because in manyinstances the participants can devise more satisfactory solutions to their disputes thancan professionals constrained to apply general rules on the basis of limited knowledgeof the dispute. Such a view is broadly consonant with the concept of a contract as aframework, where the major importance of a legal contract is to provide a framework whichnever accurately indicates real working relations, but which affords a rough indicationaround which such relations vary, an occasional guide in cases of doubt, and a norm ofultimate appeal when the relations cease in fact to work (Williamson, 2002b).

Theory of Core Competencies

Core competencies theory suggests activities should be performed either in-house or bysuppliers. Activities, which are not core competencies, should be considered foroutsourcing with best-in-world suppliers. Some noncore activities may have to beretained in-house if they are part of a defensive posture to protect competitive advantage.Although some authors indicate characteristics of core competencies, most of theliterature on this subject seems tautological—core equals key or critical or fundamental.Employees in noncore functions (even if not facing outsourcing) may feel excluded bythe organization because they are a nondominant discipline. For example, IT employees



working on Web-based legal services in a law firm may feel excluded by lawyers in thefirm. In the public sector, there may be particular uncertainty about what is core; and ithas been suggested that the government may aim to discover its core competencies viaa residualization process—outsourcing until and unless the shoe pinches, or a politicalbacklash is triggered (Hancox & Hackney, 2000).An organization may view IT itself as a core competency. It seems that most successfulcompanies have a good understanding of IT’s potential. However, some organizationsoutsource IT even though they see it as core and delivering competitive advantage. Thismay be because IT can be considered core at the corporate level, but some of its aspects,at lower levels, might be commodities. Thus the complexity of IT, and its (at least in part)core nature, may make the contracting out of IT a particularly challenging exercise. Theability to define IT requirements and to monitor their delivery by third parties may be someof the core IT competencies that any organization must have if it is to outsource ITsuccessfully. It can even be argued that the very acts of specifying and managing supplycontracts can themselves give competitive advantage.Hancox and Hackney (2000) interviewed IT managers to find support for the corecompetencies theory in IT outsourcing. Contrary to vendors’ marketing material and toomuch of the literature on IT outsourcing, concentration on core competencies did notappear to be a strong motive for IT outsourcing among the sample organizations. Noorganization from either private or public sector had systematically examined its activi-ties to identify core and noncore functions. Most organizations seemed to share the viewof IT as a mix of core and noncore activities.According to Prahalad and Hamel (1990), core competencies are the collective learningin the organization, especially how to coordinate diverse production skills and integratemultiple streams of technologies. Since core competency is about harmonizing streamsof technology, it is also about the organization of work and the delivery of value. Theforce of core competency is felt as decisively in services as in manufacturing. Corecompetency does not diminish with use. Unlike physical assets, which do deteriorateover time, competencies are enhanced as they are applied and shared. But competenciesstill need to be nurtured and protected; knowledge fades if it is not used. Competenciesare the glue that binds existing businesses. They are also the engines for new businessdevelopment. At least three tests can be applied to identify core competencies in acompany. First, a core competency provides potential access to a wide variety of markets.Second, a core competency should make a significant contribution to the perceivedcustomer benefits of the end product. Finally, a core competency should be difficult forcompetitors to imitate. The tangible link between identified core competencies and endproducts is what Prahalad and Hamel (1990) call core products—the embodiments of oneor more core competencies. Core products are the components or subassemblies thatactually contribute to the value of the end products.Core competencies are sometimes called firm-specific competence, resource deploy-ments, invisible assets, and distinctive competencies. Leonard-Barton (1992) called themcore capabilities. Capabilities are considered core if they differentiate a companystrategically. The concept is not new. Their strategic significance has been discussedfor decades, stimulated by research discovery that of nine diversification strategies, thetwo that were built on an existing skill or resource base in the firm were associated withthe highest performance. The observation that industry-specific capabilities increased



the likelihood a firm could exploit a new technology within that industry, has confirmedthe early work. Therefore some authors suggest that effective competition is based lesson strategic leaps than on incremental innovation that exploits carefully developedcapabilities. On the other hand, institutionalized capabilities may lead to incumbentinertia in the face of environmental changes. Technological discontinuities can enhanceor destroy existing competencies within an industry. Such shifts in the external environ-ment resonate within the organization, so that even seemingly minor innovations canundermine the usefulness of deeply embedded knowledge. All innovation necessarilyrequires some degree of creative destruction.Leonard-Barton (1992) adopted a knowledge-based view of the firm and defined a corecapability as the knowledge set that distinguishes and provides a competitive advan-tage. There are four dimensions to this knowledge set. Its content is embodied in (1)employee knowledge and skills and embedded in (2) technical systems. The processesof knowledge creation and control are guided by (3) managerial systems. The fourthdimension is (4) the values and norms associated with the various types of embodied andembedded knowledge and with the processes of knowledge creation and control.The belief that outsourcing of IT is only appropriate when IT is not considered a corefunction of the firm’s industry was not held by executives interviewed by McLellan,Marcolin, and Beamish (1995). Core activities were defined by a firm’s management asthose that provided the competitive capabilities that lead to competitive advantage. Thisdefinition implies that a core activity is central to the competitive nature of the industry.The executives involved in outsourcing relationships clearly viewed the IT function ascentral to their competitiveness within the banking industry, yet firms still chose tooutsource much if not all of the IT activities. The decision was in direct contrast to theconventional outsourcing wisdom. The rationale discerned from the executives’ discus-sions was as follows. An activity that contributes to the competitive capabilities of acompany is considered to be core. In the banking industry, the executives clearly viewedIT as one of these activities. Outsourcing offers an opportunity to use resources beyondthose contained in the bank to increase competitive capabilities within the IT function.Vendor and bank capabilities were combined to create competitive advantage.The unique advantage came from combining the vendor’s resources with the bank’s, ata time when no other competitor was doing the same. The combination might not besustainable in the long term, but it gave competitive advantage to the bank at the time.Long-term advantage will depend on identifying the next unique combination no one elseis exploiting in the marketplace; however, sustainable competitive advantage is stron-gest if tied to firm-specific capabilities. These banks created competitive advantage byexploiting their own strengths and market situations while drawing upon the IT resourcesof the vendor (McLellan et al., 1995).Quinn and Hilmer (1994) discuss strategic outsourcing and argued that if suppliermarkets were totally reliable and efficient, rational companies would outsource every-thing except those special activities in which they could achieve unique competitiveedge, that is, their core competencies. The essence of core competencies consist of (1)skill or knowledge set, not products or functions, (2) flexible, long-term platforms—capable of adaptation or evolution, (3) limited in number, (4) unique sources of leveragein the value chain, (5) areas where the company can dominate, (6) elements important tocustomers in the long run, and (7) embedded in the organization’s systems.



Since most supplier markets are imperfect, Quinn and Hilmer (1994) recommended thatmanagers must answer three key questions about any activity considered for outsourcing.First, what is the potential for obtaining competitive advantage in this activity, takinginto account transaction costs? Second, what is the potential vulnerability that couldarise from market failure if the activity is outsourced? Third, what can we do to alleviateour vulnerability by structuring arrangements with suppliers to provide appropriatecontrols yet provide for necessary flexibilities in demand? When the potentials for bothcompetitive edge and strategic vulnerability are high, the company needs a high degreeof control, usually entailing the activity internally or through joint-ownership arrange-ments or tight long-term contracts.Lislie (2003) suggests that a core competency can be outsourced. His example is duediligence that private equity groups do of target companies. He argues that the corecompetency of a private equity group is analyzing business strategy due diligence ofacquisition targets. Nevertheless, he suggests that private equity groups shouldconsider hiring an outside research-based strategy consulting firm to ensure the processis conducted thoroughly, systematically, and efficiently. His main arguments foroutsourcing of core competency in this case are conflicting priorities and operatingcosts.Aung and Heeler (2001) identified three schools of core competency. The first definesthe term “core competencies” to cover all the resources possessed by an organization.The second defines it as just one of the resources possessed by an organization. Fromthis vantage point, the successful firm has a number of resource-tangible assets andintangible assets such as its unique history and evolution as well as its uniquecompetencies. This is what we call the resource-based theory. The third also defines corecompetencies as pure skills, but it emphasizes that they are the determinant resourcesfor a firm’s competitive advantage. The focus of this school of thought is on thedeterminant skills and know-how possessed by an organization. This determinant schoolof thought seems the most appropriate to study today’s competition as more recentstudies indicate that differences in starting resources positions may be less importantthan differences in abilities to leverage corporate resources.The concept of competence is important, but Williamson (1999) finds that a relentlesscommitment to the operationalization of competence is needed. Awaiting such develop-ments, the competence perspective relies primarily on success stories to make its case.Core competencies must be derived by looking across the range of a firm’s (and itscompetitors’) products and services. This is very nearly circular in that it comesperilously close to saying that a core competency is a competency that is core. Forexample, Kodak’s core competency might be considered imaging, and IBM’s might beconsidered integrated data processing and service.Concepts of core competency are expansive and elastic. The ideas that firms possessboth strengths (competencies) and weaknesses (disabilities) and that they are engagedin intertemporal competency tradeoffs (in relation to which the condition of competitionplays an important role) are underdeveloped. There being one apparatus by which toadvise firms on when and how to reconfigure their core competencies, the argument relieson ex post rationalization: show me a success story and I will show you (uncover) a corecompetency (Williamson, 1999). The competency perspective rejects the idea of the firm



as a production function and emphasizes management and organization features instead.Starting from the basic unit of analysis, suppose that the firm is described as theaggregation of those basic units for which internal organization enjoys a comparativeadvantage. The firm then is a bundle of related resources (from the resource-basedperspective), a bundle of routines (from the evolutionary perspective), and a bundle oftransactions/contracts (from the transaction cost economics perspective). The compe-tence perspective can answer the key questions of the existence, structure, and bound-aries of the firm.Quinn (1999) argues that core competencies are not products or “those things we dorelatively well.” They are those activities—usually intellectually based service activitiesor systems—that the company performs better than any other enterprise. They are thesets of skills and systems that a company does at best-in-the-world levels and throughwhich a company creates uniquely high value for customers. Developing best-in-the-world capabilities is crucial in designing a core competency strategy. Unless thecompany is best-in-the-world at an activity—whether within a function orinterfunctionally—it is someone else’s core competency, not its own. The companygives up competitive edge by not buying that skill from a best-in-the-world source.

Agency Theory

Agency theory has broadened the risk-sharing literature to include the agency problemthat occurs when cooperating parties have different goals and division of labor. Thecooperating parties are engaged in an agency relationship defined as a contract underwhich one or more persons (the principal[s]) engage another person (agent) to performsome service on their behalf which involves delegating some decision-making authorityto the agent (Jensen & Meckling, 1976). Agency theory describes the relationshipbetween the two parties using the metaphor of a contract. In an IT outsourcingrelationship this is a client–vendor relationship and an outsourcing contract.According to Eisenhardt (1985), agency theory is concerned with resolving two problemsthat can occur in agency relationships. The first is the agency problem that arises whenthe desires or goals of the principal and agent conflict and it is difficult or expensive forthe principal to verify what the agent is actually doing. The second is the problem of risksharing that arises when the principal and agent have different risk preferences. Theseproblems are well known in IT outsourcing. An example might be that the clientorganization wants to reduce its IT costs, while the vendor organization wants tomaximize profits. The agency problem arises when the two parties do not share produc-tivity gains. The risk-sharing problem might be the result of different attitudes towardthe use of new technologies. Because the unit of analysis is the contract governing therelationship between the two parties, the focus of the theory is on determining the mostefficient contract governing the principal–agent relationship given assumptions aboutpeople (e.g., self-interest, bounded rationality, risk aversion), organizations (e.g., goalconflict of members), and information (e.g., information is a commodity which can bepurchased). Thus the question becomes “Is a behavior-oriented contract more efficient



than an outcome-oriented contract?” Outsourcing contracts are to a great extent tied upto service-level agreements, where the outcome of the service is the focal point.The agency theory is applicable when describing client-vendor relationships in IToutsourcing arrangements. Typically, the client organization (principal) transfers prop-erty rights to the vendor organization (agent). In the context of IT, assets transferredmight be infrastructure, systems and documentation and employees. For a certainamount of money, the vendor organization provides services to the client organization.This implies a change in legal relationships, and IT services are carried out using a moreformal transaction process. The status of personal relationships also changes, from thatof a manager and a subordinate, to that of a client-manager and a vendor. According toagency theory, control mechanisms also change, from that of behavioral control to thatof outcome-based control. If both parties to the relationship are trying to maximize theirutility, there is good reason to believe that the vendor organization will not always actin the best interests of the client. Monitoring and bonding activities in reducing agencycosts include auditing, formal control systems, budget restrictions, and the establish-ment of incentive compensation systems, which serve to more closely identify themanager’s interests with those of the outside equity holder.The original impetus for the development of agency theory was large corporations’separation of control from ownership. Thus, its focus was never on organizationalboundaries, as with transaction cost theory. Agency theory’s primary interest is not thedecision to source via the hierarchy or via the market. Although all contractual arrange-ments contain important elements of agency, agency theory is essentially concernedwith the delegation of work by the principal to the agent via a contract, whether they areboth within the same organization. However, agency and transaction cost theories shareseveral concepts, such as opportunism, uncertainty, and bounded rationality, and thereis a rough correspondence between transaction cost economics’ hierarchies and marketsand agency theory’s behavior-based contracts and outcome-based contracts.According to Hancox and Hackney (2000), the choice of contract type depends on theagency costs, which include the principal’s effort in assessing the agent’s performanceand the agent’s efforts in assuring the principal of his commitment. Agency theory holdsthat human beings act through self-interest and, therefore as contracting parties, theymay have divergent goals. An important aspect of the theory is that both principal andagent wish to avoid risk when dealing with each other. The principal may prefer to placerisk with the agent via an outcome-based contract, whereas the agent may prefer to avoidrisk by having a behavior-based contract.Outcome-based contracts are claimed to reduce agent opportunism because the rewardsof both agent and principal depend on the same actions. Behavior-based contracts needthe principal to have sufficient information to identify two possible dangers: first,whether there is adverse selection (the agent does not possess the skills he claims);second, moral hazard—the agent is shirking. Overall risk may be reduced by sourcing viathe hierarchy, but agency costs also exist in hierarchies. Problems between agents andprincipals are greater in complex organizations with many managerial layers. Given thatmany public sector bodies are large and complicated both in the range of their activitiesand the structures adopted to manage and account for those activities, it may be thatagency costs are inclined to be higher in the public sector. Nonmarket organizations may



be especially susceptible to influence costs, where employees pursue their own agenda.This might imply that within a public sector organization if the employees of onedepartment were motivated by self-interest then workers in other departments would beinconvenienced and resent the action, unless perhaps, they themselves were pursuinga similar or compatible agenda.The technological and business complexity of IT means that there may be major problemsfor the principal in choosing a suitable agent and in monitoring the agent’s work. Onlythe agent knows how hard he is working, and that can be especially important inmultilateral contracting where one agent acts for several principals. This is often the casein IT outsourcing because of the market dominance of one large firm. Given the difficultiesof behavior-based contracts suggested by agency theory, it is reasonable to assume thatthe overwhelming majority of clients would insist on outcome-based contracts whenacquiring IT products and services. Such a strategy can only succeed if the client canconfidently specify current and future requirements. But accurate predictions by theclient may not always be in the vendor’s interests; since vendor account managers oftenare rewarded according to contract profitability, which is principally achieved throughcharging the client extra for anything that is not in the contract.Hancox and Hackney (2000) interviewed IT managers to find support for agency theoryin IT outsourcing. In their interviews, it was difficult to find examples of some of the ideasfrom agency theory, although a minority of the organizations had been disappointed withaspects of vendor performance and behavior.

Resource-Based Theory

The central tenet in resource-based theory is that unique organizational resources ofboth tangible and intangible nature are the real source of competitive advantage. Withresource-based theory, organizations are viewed as a collection of resources that areheterogeneously distributed within and across industries. Accordingly, what makes theperformance of an organization distinctive is the unique blend of the resources itpossesses. A firm’s resources include not only its physical assets such as plant andlocation but also its competencies. The ability to leverage distinctive internal andexternal competencies relative to environmental situations ultimately affects the perfor-mance of the business.Exploring competencies in the context of the management of IT is a relatively recentdevelopment in the evolution of the IS discipline. The importance of developingcompetencies that allow organizations to successfully take advantage of information intheir specific context has been noted. The concept of competence in the IS literature ispredominantly focused upon individual competence in the form of IT skill sets rather thantreated as an organizational construct. The focus has been on the technology supply sideand individuals’ skills, emphasizing the requirement for IT professionals to have not justtechnical skills but also business and interpersonal skills. More recently, change agentryas a skill for IT professionals has been proposed. The implication of this literature streamis that the solution to the problem of lacking benefits from IT can be solved by equipping



IT specialists with additional skills. The inference is that the inability to deliver value frominformation arises from shortcomings in the IT function and among IT professionals(Peppard, Lambert, & Edwards, 2000).Outsourcing gives a client organization access to resources in the vendor organizationas the vendor handles IT functions for the client. Vendor resources can produceinnovation, which is essential for long-term survival of the client. Quinn (2000) arguesthat the time is right for outsourcing innovation. Four powerful forces are currentlydriving the innovation revolution. First, demand is growing fast in the global economy,creating a host of new specialist markets sufficiently large to attract innovation. Second,the supply of scientists, technologists, and knowledge workers has skyrocketed, as haveknowledge bases and the access to them. Third, interaction capabilities have grown.Fourth, new incentives have emerged.Transformational outsourcing, as described in Chapter II, is an emerging practice to bringnew capabilities to the organization. Resources are required to bring new capabilities, andresources bringing new capabilities can be found in an outsourcing vendor. In thiscontext we apply the knowledge-based view of the firm that has established itself as animportant perspective in strategic management. This perspective builds on the resource-based theory of the firm. According to the resource-based theory of the firm, performancedifferences across firms can be attributed to the variance in the firms’ resources andcapabilities. Resources that are valuable, unique, and difficult to imitate can provide thebasis for firms’ competitive advantages. In turn, these competitive advantages producepositive returns. According to Hitt, Bierman, Shumizu, and Kochhar (2001), most of thefew empirical tests of the resource-based theory that have been conducted havesupported positive, direct effects of resources.The essence of the resource-based theory of the firm lies in its emphasis on the internalresources available to the firm, rather than on the external opportunities and threatsdictated by industry conditions. Firms are considered to be highly heterogeneous, andthe bundles of resources available to each firm are different. This is both because firmshave different initial resource endowments and because managerial decisions affectresource accumulation and the direction of firm growth as well as resource utilization(Løwendahl, 2000).The resource-based theory of the firm holds that, in order to generate sustainablecompetitive advantage, a resource must provide economic value and must be presentlyscarce, difficult to imitate, nonsubstitutable, and not readily obtainable in factor markets.This theory rests on two key points. First, that resources are the determinants of firmperformance, and second, that resources must be rare, valuable, difficult to imitate, andnonsubstitutable by other rare resources. When the latter occurs, a competitive advan-tage has been created. Resources can simultaneously be characterized as valuable, rare,nonsubstitutable, and inimitable. To the extent that an organization’s physical assets,infrastructure, and workforce satisfy these criteria, they qualify as resources. A firm’sperformance depends fundamentally on its ability to have a distinctive, sustainablecompetitive advantage, which derives from the possession of firm-specific resources(Priem & Butler, 2001). The resource-based theory is a useful perspective in strategicmanagement. Research in the competitive implications of such firm resources as knowl-edge, learning, culture, teamwork, and human capital was given a significant boost by



resource-based theory—a theory that indicated it was these kinds of resources that weremost likely to be sources of sustainable competitive advantage for firms (Barney, 2001).Firms’ resource endowments, particularly intangible resources, are difficult to changeexcept over the long term. For example, although human resources may be mobile to someextent, capabilities may not be valuable for all firms or even for their competitors. Somecapabilities are based on firm-specific knowledge and others are valuable when inte-grated with additional individual capabilities and specific firm resources. Therefore,intangible resources are more likely than tangible resources to produce a competitiveadvantage. In particular, intangible firm-specific resources such as knowledge allowfirms to add value to incoming factors of production (Hitt et al., 2001). Resource-basedtheory attributes advantage in an industry to a firm’s control over bundles of uniquematerial, human, organizational and locational resources, and skills that enable uniquevalue-creating strategies. A firm’s resources are said to be a source of competitiveadvantage to the degree that they are scarce, specialized, appropriable, valuable, rare,and difficult to imitate or substitute.

Capabilities and Resources

A fundamental idea in resource-based theory is that a firm must continually enhance itsresources and capabilities to take advantage of changing conditions. Optimal growthinvolves a balance between the exploitation of existing resource positions and thedevelopment of new resource positions. Thus, a firm would be expected to develop newresources after its existing resource base has been fully utilized. Building new resourcepositions is important if the firm is to achieve sustained growth. When unused produc-tive resources are coupled with changing managerial knowledge, unique opportunitiesfor growth are created (Pettus, 2001).The term “resource” is derived from the Latin “resurgere,” which means, “to rise” andimplies an aid or expedient for reaching an end. A resource implies a potential means toachieve an end, or as something that can be used to create value. The first strategytextbooks outlining a holistic perspective focused on how resources needed to beallocated or deployed to earn rents. The interest in the term was for a long time linked tothe efficiency of resource allocation, but this focus has later been expanded to issuessuch as resource accumulation, resource stocks, and resource flows (Haanes, 1997).Firms develop firm-specific resources and then renew these to respond to shifts in thebusiness environment. Firms develop dynamic capabilities to adapt to changing envi-ronments. According to Pettus (2001), the term dynamic refers to the capacity to renewresource positions to achieve congruence with changing environmental conditions. Acapability refers to the key role of strategic management in appropriately adapting,integrating, and reconfiguring internal and external organizational skills, resources, andfunctional capabilities to match the requirements of a changing environment. If firms areto develop dynamic capabilities, learning is crucial. Change is costly; therefore, theability of firms to make necessary adjustments depends upon their ability to scan theenvironment to evaluate markets and competitors and to quickly accomplishreconfiguration and transformation ahead of competition. However, history matters.Thus, opportunities for growth will involve dynamic capabilities closely related to



existing capabilities. As such, opportunities will be most effective when they are closeto previous resource use.According to Johnson and Scholes (2002), successful strategies are dependent on theorganization having the strategic capability to perform at the level that is required forsuccess. So the first reason why an understanding of strategic capability is importantis concerned with whether an organization’s strategies continue to fit the environmentin which the organization is operating and the opportunities and threats that exist. Manyof the issues of strategy development are concerned with changing strategic capabilitybetter to fit a changing environment. Understanding strategic capability is also importantfrom another perspective. The organization’s capability may be the leading edge ofstrategic developments, in the sense that new opportunities may be created by stretchingand exploiting the organization’s capability either in ways which competitors finddifficult to match or in genuinely new directions, or both. This requires organizations tobe innovative in the way they develop and exploit their capability. In this perspective,strategic capability is about providing products or services to customers that are valuedor might be valued in the future. An understanding of what customers’ value is thestarting point. The discussion then moves to whether an organization has the resourcesto provide products and services that meet these customer requirements.Resource is anything that could be thought of as a strength or weakness of a given firm.More formally, a firm’s resources at a given time can be defined as those (tangible andintangible) assets that are tied to the firm over a substantial period of time. Examples ofresources are brand names, in-house knowledge of technology, employment of skilledpersonnel, trade contracts, machinery, efficient procedures, capital, and so forth.According to the economic school, resources include human capital, structural capital,relational capital, and financial capital. Priem and Butler (2001) find it problematic thatvirtually anything associated with a firm can be a resource, because this notion suggeststhat prescriptions for dealing in certain ways with certain categories of resources mightbe operationally valid, whereas other categories of resources might be inherently difficultfor practitioners to measure and manipulate. One example of a resource that might bedifficult to measure and manipulate is tacit knowledge. Some have argued for tacitknowledge—that understanding gained from experience but that sometimes cannot beexpressed to another person and is unknown to oneself—as a source of competitiveadvantage. Another example is the CEO resource. Prescriptions have been made to topmanagers of poorly performing firms that they are the cause of the problem and that theyshould think about voluntarily exiting the firm. This is a case where viewing a CEO as aresource would have more prescriptive implications for boards of directors than for theCEO.Barney (2002) discusses how value, rarity, imitability, and organization can be broughttogether into a single framework to understand the return potential associated withexploiting any of a firm’s resources and capabilities. The framework consists of thefollowing five steps:

1. If a resource or capability controlled by a firm is not valuable, that resource willnot enable a firm to choose or implement strategies that exploit environmentalopportunities or neutralize environmental threats. Organizing to exploit this re-



source will increase a firm’s costs or decrease its revenues. These types ofresources are weaknesses. Firms will either have to fix these weaknesses or avoidusing them when choosing and implementing strategies. If firms do exploit thesekinds of resources and capabilities, they can expect to put themselves at acompetitive disadvantage compared to firms that either do not possess thesenonvaluable resources or do not use them in conceiving and implementingstrategies. Firms at a competitive disadvantage are likely to earn below-normaleconomic profits.

2. If a resource or capability is valuable but not rare, exploiting this resource inconceiving and implementing strategies will generate competitive parity andnormal economic performance. Exploiting these valuable-but-not-rare resourceswill generally not create above-normal economic performance for a firm, but failureto exploit them can put a firm at a competitive disadvantage. In this sense, valuable-but-not-rare resources can be thought of as organizational strengths.

3. If a resource or capability is valuable and rare but not costly to imitate, exploitingthis resource will generate a temporary competitive advantage for a firm and above-normal economic profits. A firm that exploits this kind of resource is, in an importantsense, gaining a first-mover advantage, because it is the first firm that is able toexploit a particular resource. However, once competing firms observe this competi-tive advantage, they will be able to acquire or develop the resources needed toimplement this strategy through direct duplication or substitution at no costdisadvantage compared to the first-moving firm. Over time, any competitiveadvantage that the first mover obtained would be competed away as other firmsimitate the resources needed to compete. However, between the time a firm gainsa competitive advantage by exploiting a valuable and rare but imitable resource orcapability, and the time that competitive advantage is competed away throughimitation, the first-moving firm can earn above-normal economic performance.Consequently, this type of resource or capability can be thought of as anorganizational strength and distinctive competence.

4. If a resource is valuable, rare, and costly to imitate, exploiting this resource willgenerate a sustained competitive advantage and above-normal economic profits.In this case, competing firms face a significant cost disadvantage in imitating asuccessful firm’s resources and capabilities, and thus cannot imitate this firm’sstrategies. This advantage may reflect the unique history of the successful firm,causal ambiguity about which resources to imitate, or the socially complex natureof these resources and capabilities. In any case, attempts to compete away theadvantages of firms that exploit these resources will not generate above-normal oreven normal performance for imitating firms. Even if these firms were able to acquireor develop the resources and capabilities in question, the very high costs of doingso would put them at a competitive disadvantage compared to the firm that alreadypossessed the valuable, rare, and costly to imitate resources. These kinds ofresources and capabilities are organizational strengths and sustainable distinctivecompetencies.

5. The question of organization operates as an adjustment factor in the framework.If a firm with a resource that is valuable, rare, and costly to imitate, is disorganized,



some of its potential above-normal return could be lost. If the firm completely failsto organize itself to take advantage of this resource, it could actually lead the firmthat has the potential for above-normal performance to earn normal or even below-normal performance.

Barney (2001) discusses how value and rarity of resources can be determined. Value isa question of conditions under which resources will and will not be valuable. Models ofthe competitive environment within which a firm competes can determine value. Suchmodels fall into two large categories: (1) efforts to use structure-conduct-performance-based models to specify conditions under which different firm resources will be valuableand (2) efforts to determine the value of firm resources that apply other models derivedfrom industrial organization models of perfect and imperfect competition. As an exampleof resource value determination, Barney discusses the ability of cost leadership strategyto generate sustained competitive advantage. Several firm attributes may be associatedwith cost leadership, such as volume-derived economies of scale, cumulative volume-derived learning curve economies and policy choices. These firm attributes can be shownto generate economic value in at least some market settings. The logic used to demon-strate the value of these attributes is a market structure logic that is consistent withtraditional microeconomics. After identifying the conditions under which cost leader-ship can generate economic value, it is possible to turn to the conditions under whichcost leadership can be a source of competitive advantage (i.e., rare) and sustainedcompetitive advantage (i.e., rare and costly to imitate).The resource-based theory postulates that some resources will have a higher value forone firm than for other firms. The reasons why the value of resources may be firm specificare multiple and include (Haanes, 1997): the experience of working together as a team, thefirm possessing superior knowledge about its resources, the bundling of the resources,and the existence of cospecialized or complementary assets. The value of a givenresource may change over time as the market conditions change, for example, in termsof technology, customer preferences, or industry structure. Thus, it is often argued thatfirms need to maintain a dynamic, as opposed to static, evaluation of the value of differentresources.Rarity is a question of how many competing firms possess a particular valuable resource.If only one competing firm possesses a particular valuable resource, then that firm cangain a competitive advantage, that is, it can improve its efficiency and effectiveness inways that competing firms cannot. One example of this form of testable assertion ismentioned by Barney (2001). The example is concerned with organizational culture as asource of competitive advantage. If only one competing firm possesses a valuableorganizational culture (where the value of that culture is determined in ways that areexogenous to the firm), then that firm can gain a competitive advantage, that is, it canimprove its efficiency and effectiveness in ways that competing firms cannot. Both theseassertions are testable. If a firm uniquely possesses a valuable resource and cannotimprove its efficiency and effectiveness in ways that generate competitive advantages,then these assertions are contradicted. One could test these assertions by measuring theextent to which a firm uniquely possesses valuable resources, for example, valuableorganizational culture, measuring the activities that different firms engage in to improvetheir efficiency and effectiveness, and then seeing if there are some activities a firm with



the unique culture engages in to improve its effectiveness and efficiency—activities notengaged in by other competing firms. In general, the rarity of a resource is present as longas the number of firms that possess a particular valuable resource is less than the numberof firms needed to generate perfect competition dynamics. Of course, there is difficultmeasurement problems associated with testing assertions of this form. Barney (2001)points out that additional research is needed to complete the parameterization of theconcept of rarity. Efficient firms can sustain their competitive advantage only if theirresources can neither be extended freely nor imitated by other firms. Hence, in order forresources to have the potential to generate rents, they must be rare. Valuable but commonresources cannot by themselves represent sources of competitive advantage becausecompetitors can access them. No one needs to pay extra for obtaining a resource that isnot held in limited supply.In addition to value and rarity, inimitability has to be determined. Inimitability can bedetermined through barriers to imitation and replication. The extent of barriers andimpediments against direct and indirect imitation determine the extent of inimitability.One effective barrier to imitation is that competitors fail to understand the firm’s sourcesof advantage. The lack of understanding can be caused by tacitness, complexity, andspecificity that form the bases for competitive advantage (Haanes, 1997). Several authorshave categorized resources. A common categorization is tangibles versus intangibles.Tangibles are relatively clearly defined and easy to identify. Tangible resources includeplants, technology, land, and geographical location, access to raw materials, capital,equipment, and legal resources. Tangible resources tend to be property-based and mayalso include databases, licenses, patents, registered designs, and trademarks, as well asother property rights that are easily bought and sold. Intangibles are more difficult todefine and also to study empirically. Intangible resources encompass skills, knowledge,organizational capital, relationships, capabilities, and human capital, as well as brands,company and product reputation, networks, competencies, perceptions of quality, andthe ability to manage change. Intangible resources are generally less easy to transfer thantangible resources, as the value of an intangible resource is difficult to measure.

Slack Resources

Ang (1993) has studied the etiology of IT outsourcing. Any analysis of outsourcing willtypically incorporate the effects of managerial discretionary power on substantiveadministrative choices. Inclusion of managerial-behavioral factors to understandingoutsourcing is consistent with the view of managerial choices to be the primary linkbetween an organization and its environment. The importance of managerial discretionin the operations of the firm has been widely acknowledged in organization theory. Ingeneral, the separation of ownership from control of the firm gives rise to problems ofcontrolling managerial behavior. It can be emphasized that when ownership is thinlyspread over a large number of shareholders in a firm, control lies in the hands of themanagers who themselves own only a tiny fraction of the firm’s equity. These circum-stances permit managers greater discretion and decision latitude over substantivedomains such as resource allocation, administrative choices, and product market selec-tion.



Organizations with abundant slack tend to induce greater managerial discretion. Slackis defined as the difference between total resources and total necessary payments. Itrefers to the excess that remains once a firm has paid its various internal and externalconstituencies to maintain their cooperation. Slack can further be defined as a cushionof excess resources available in an organization that will either solve many organizationproblems or facilitate the pursuit of goals outside the realm of those dictated byoptimization principles. An organization’s slack reflects its ability to adapt to unknownor uncertain future changes in its environment. Accordingly, uncommitted or transfer-able slack resources would expand the array of options available to management. Insteadof distributing slack resources back to shareholders, managers tend to retain and investslack resources in new employees, new equipment, and other assets to promote assetcapitalization. One primary reason for retaining earnings within the organization is thatincreased asset capitalization, the primary indicator of firm size, enhances the socialprominence, public prestige, and political power of senior executives.Investments in IT represent a major approach to asset capitalization in organizations. ITmay symbolize firm growth, advancement, and progress. Because investments in IT canpromote social prominence and public prestige, managers are induced to utilize slackresources to internalize IS services. Inducements toward investments in in-house ISservices are further reinforced by well-publicized case studies that demonstrate thecompetitive advantage and new business opportunities afforded by IT. The abovereasoning suggests that managers may exhibit a penchant for building up internal ITresources such as IS employees, equipment, and computer capacity when organizationspossess slack resources. In contrast, when slack resources are low, managers tend toconserve resources in response to the anxiety provoked by loss of financial resources.Anxiety is provoked because the loss of financial resources is often attributed tomanagerial incompetence and organizational ineffectiveness. As a result, leaders aremore likely to be blamed and replaced when financial performance is poor. In responseto the anxiety provoked by loss of financial resources, decision makers have beenobserved to reduce costs through downsizing the company by selling off physical assetsand laying off workers.Companies may even sell IT assets at inflated rates to external service providers togenerate short-term financial slack. The companies then reimburse the service providerby paying higher annual fees for a long-term outsourcing contract lasting 8 to 10 years.In other words, long-term facilities management contracts can be drawn where the serviceproviders agree to purchase corporate assets, such as computer equipment, at pricessubstantially higher than the market value and to provide capital to the company bypurchasing stock from the company. Arrangements such as these permit companies tomaintain capital, defer losses on the disposition of assets, and at the same time, showan increase in financial value on the balance sheet. But because these arrangements alsoinvolve companies paying higher fees over the life of the contract, company financialstatements are thus artificially inflated and do not reflect the true financial picture of theinstitution.According to Ang (1993), when slack resources are low, we would expect firms todownsize internal IS services by selling off IT assets, and reducing IS personnel andoccupancy expenses, in effect, outsourcing IS services. Thus, we would expect that firms



are less likely to outsource when slack resources are high and more likely to outsourcewhen slack resources are low.Besides managerial discretion over slack resources, top management’s perception of thecriticality of IT may differ. According to the dependence-avoidance perspective of thefirm, organizations will avoid comprising their autonomy, particularly when the resourceis vital for the organization’s survival. The strength of an organization’s aversion to lossof autonomy is thus a function of the criticality of the resource. The organization willproactively struggle to avoid external dependency, that is, outsourcing, regardless ofefficiency considerations as long as it depends on IT for survival. The value of IT forcompetitive advantage intensifies the pressure on firms to internalize sophisticated ISservices to avoid leakage of competitive information.Although it is generally accepted that IT is critical for information-intensive firms, notall members of top management teams attach the same degree of criticality to IT.Perceptions of the CIOs and CEOs of IT importance tend to be misaligned. While CIOsrecognize IT as vital to an organization’s strategy, CEOs with little background in IT tendto regard IS services as backroom operations, an expense to be controlled rather than astrategic investment to be capitalized. Generally, CEOs’ perceptions of IT criticality areas important as, if not more important than, those of the CIOs’ with respect to IS sourcingdecisions because IS investments represent a significant financial outlay for corpora-tions. Sometimes management policies and direction of IT use are dictated by the CEOs’psychological involvement and participation in IS. Thus, we would expect that thegreater the perceived criticality of IT to the firm, the less likely the firm will outsource itsIS services (Ang, 1993).

Company Boundaries

For many years, researchers have sought to better understand why companies adoptdifferent modes of governance. The resource-based view of the firm focuses on theopportunity for gain from transactions. A technology’s potential for rendering asustained competitive advantage will influence governance modes for external technol-ogy sourcing. The fundamental tenets of a resource-based perspective suggest apositive relationship between the perceived opportunity for sustainable advantage andthe probability that a company will source technology with an acquisition from externalsources (Steensma & Corley, 2001).Sourcing technology from outside the organization changes company boundary be-tween the firm that desires the know-how (the sourcing firm) and the firm that has thetechnology (the source firm). Managers must assess the governance alternatives forprocuring desired technological know-how. According to classical decision theory,strategic decisions such as these entail a trade-off between risk and expected return,where risk is conceptualized as the variance of the probability distribution of the gainsand losses of a particular alternative.Steensma and Corley (2001) investigate organizational context as a moderator of theorieson firm boundaries for technology sourcing. They find that the resource-based rationale,grounded on the opportunity to develop sustainable advantages, plays a larger role in



explaining firm boundaries when a firm has lower levels of recoverable slack and a risk-seeking orientation than when a firm has higher slack and risk averseness. Organizationalslack is defined as an organization’s excess resources, while firm risk orientation isdefined as expected outcome uncertainty.

Resource-Based Strategy

Strategic management models traditionally have defined the firm’s strategy in terms ofits product/market positioning—the products it makes and the markets its serves. Theresource-based approach suggests, however, that firms should position themselvesstrategically based on their unique, valuable, and inimitable resources and capabilitiesrather than the products and services derived from those capabilities. Resources andcapabilities can be thought of as a platform from which the firm derives various productsfor various markets. Leveraging resources and capabilities across many markets andproducts, rather than targeting specific products for specific markets, becomes thestrategic driver. While products and markets may come and go, resources and capabilitiesare more enduring. Therefore, a resource-based strategy provides a more long-term viewthan the traditional approach, and one more robust in uncertain and dynamic competitiveenvironments. Competitive advantage based on resources and capabilities therefore ispotentially more suitable than that based solely on product and market positioning (Zack,1999).According to Hitt et al. (2001), scholars argue that resources form the basis of firmstrategies and are critical in the implementation of those strategies as well. Therefore, firmresources and strategy seem to interact to produce positive returns. Firms employ bothtangible resources (such as buildings and financial resources) and intangible resources(like human capital and brand equity) in the development and implementation of strategy.Outside of natural resource monopolies, intangible resources are more likely to producea competitive advantage because they are often rare and socially complex, therebymaking them difficult to imitate.Following Barney (2001), resource-based theory includes a very simple view about howresources are connected to the strategies a firm pursues. It is almost as though once afirm becomes aware of the valuable, rare, costly to imitate, and nonsubstitutableresources it controls, the actions the firm should take to exploit these resources will beself-evident. That may be true some of the time. For example, if a firm possesses valuable,rare, costly to imitate, and non-substitutional economies of scale, learning curveeconomies, access to low-cost factors of production, and technological resources, itseems clear that the firm should pursue a cost leadership strategy. However, it will oftenbe the case that the link between resources and the strategy of a firm is not being soobvious. Resource-based strategy has to determine when, where and how resources maybe useful. Such strategy is not obvious, since a firm’s resources may be consistent withseveral different strategies, all with the ability to create the same level of competitiveadvantage. In this situation, how should a firm decide which of these several differentstrategies it should pursue? According to Barney (2001) this and other questionspresented by Priem and Butler (2001) concerning the resource-based theory of the firmindicate that the theory is still a theory in many respects, and that more conceptual and



empirical research has to be conducted to make the theory more useful to businessexecutives who develop resource-based strategies for their firms.Resource-based strategy is concerned with the mobilization of resources. Since per-ceived resources merely represent potential sources of value creation, they need to bemobilized to create value. Conversely, for a specific resource to have value it has toincrease or otherwise facilitate value creation. The activity whereby tangible andintangible resources are recognized, combined, and turned into activities with the aim ofcreating value is the process here called resource mobilization. The term “resourcemobilization” is appropriate, as it incorporates the activity creation based on bothindividual and organizational resources, as well as tangibles and intangibles. Accordingto Haanes (1997), alternative terms such as “resource allocation,” “resource leveraging,”or “resource deployment” are appropriate when describing the value creation based ontangible resources, but less so for intangibles. For example, a competence cannot beallocated, as the person controlling it has full discretion over it. Moreover, the compe-tence can be used in different ways. An engineer can choose to work for a differentorganization and to work with varying enthusiasm. Also, the same engineer can choosenot to utilize his or her competence at all. The term “resource mobilization” is, thus, meantto cover the value creation based on all types of resources, and it recognizes that allactivity creation has a human aspect.In strategic management and organization theory, the importance for the firm of reducinguncertainty and its dependence on key resources that it cannot fully control has receivedmuch attention. If a large part of the resource accumulation takes place in terms ofincreased competencies that key professionals could easily use for the benefit of otheremployers, the firm needs to set priorities in terms of linking these individually controlledresources to the firm. Løwendahl (2000) suggests three alternative strategies. Thesimplest strategy, which may be acceptable to some firms, involves minimizing thedependence on individual professionals and their personal competence. In this sense,the firm chooses to avoid the dependence on individual tangibles. A second strategy isthat of linking the professionals more tightly to the firm and reducing the probability oflosing them. The third alternative strategy involves increasing the organizationallycontrolled competence resources without reducing the individually controlled re-sources. Such a strategy leads to a reduction in the relative impact of individualprofessionals on total performance, without reducing the absolute value of theircontributions. Firms that have been able to develop a high degree of organizationallycontrolled resources, including relational resources that are linked to the firm rather thanto individual employees, are likely to be less concerned about the exit and entry ofindividual professionals and more concerned about the development and maintenanceof their organizational resource base.According to Maister (1993), there is a natural but regrettable tendency for professionalfirms, in their strategy development process, to focus on new things: What new marketsdoes the firm want to enter? What new clients does the firm want to target? What newservices does the firm want to offer? This focus on new services and new markets is toooften a cop-out. A new specialty (or a new office location) may or may not make sensefor the firm, but it rarely does much (if anything) to affect the profitability or competitive-ness of the vast bulk of the firm’s existing practices. On the other hand, an improvementin competitiveness in the firm’s core businesses will have a much higher return on



investment since the firm can capitalize on it by applying it to a larger volume of business.Enhancing the competitiveness of the existing practice will require changes in thebehavior of employees. It implies new methods of operating, new skill development, andnew accountabilities. Possible strategies for being more valuable to clients can be foundin answers to the following questions (Maister, 1993):

• Can we develop an innovative approach to hiring so that we can be more valuableto clients by achieving a higher caliber of staff than the competition?

• Can we train our people better than the competition in a variety of technical andcounseling skills so that they will be more valuable in the marketplace than theircounterparts at other firms?

• Can we develop innovative methodologies for handling our matters (or engage-ments, transactions, or projects) so that our delivery of services becomes morethorough and efficient?

• Can we develop systematic ways of helping, encouraging, and ensuring that ourpeople are skilled at client counseling in addition to being top suppliers?

• Can we become better than our competition at accumulating, disseminating, andbuilding our firm-wide expertise and experience, so that each professional becomesmore valuable in the marketplace by being empowered with a greater breadth anddepth of experience?

• Can we organize and specialize our people in innovative ways, so that they becomeparticularly skilled and valuable to the market because of their focus on a particularmarket segment’s needs?

• Can we become more valuable to our clients by being more systematic and diligentabout listening to the market: collecting, analyzing, and absorbing the details oftheir business than does our competition?

• Can we become more valuable to our clients by investing in research and develop-ment on issues of particular interest to them?

In resource-based strategy, there has to be consistency between resources and busi-ness. The logic behind this requirement is that the resources should create a competitiveadvantage in the business in which the firm competes. To meet this requirement,corporate resources can be evaluated against key success factors in each business.When doing so, it is important to keep in mind that in order to justify retaining a business,or entering a business, the resources should convey a substantial advantage. Merelyhaving pedestrian resources that could be applied in an industry is seldom sufficient tojustify entry or maintain presence in an attractive industry. Moreover, managers mustremember that regardless of the advantage of a particular corporate resource appears toyield, the firm must also compete on all the other resources that are required to produceand deliver the product or service in each business. One great resource does not ensurea successful competitive position, particularly if a firm is disadvantaged on otherresource dimensions (Collis & Montgomery, 1997).



Contingency Model

Grover et al. (1998) developed a contingency model for IT outsourcing. Structuralcontingency theory has dominated the study of organizational design and performanceduring the past 20 years. It is the perspective underlying the prescribed dual approachto strategic analysis: environmental threats and opportunities analysis, and organiza-tional strengths and weaknesses. Contingency perspectives indicate that the appropri-ateness of different strategies depend on the competitive setting of business. Further,the perspectives rest on the belief that no universal set of strategic choices exists thatis optimal for all businesses, irrespective of their resource positions and environmentalcontext. Thus, effective strategies are those that achieve a fit or congruence betweenenvironmental conditions and organizational factors. The basic premise of contingencytheory is that outsourcing strategy is only one of several types of economic restructuringby which an organization adapts to the environment. Therefore, there are situationsunder which outsourcing may or may not be appropriate. Figure 4.1 puts together thevariety of contingency variables, including resource dimensions discussed earlier:

• Resource base emphasizes the necessity of critical IT resources and capabilities.• Resource dependence, though emphasizing that much organizational action is

determined by environmental conditions, recognizes the possibility of intentionaladaptation to environmental conditions through management actions.

• Agency costs are based on agency cost theory that examines the reasons forprincipal–agent relationships and the problems inherent in them. An agencyrelationship can be defined as a contract under which one or more persons–—principal(s)—engage another person—the agent—to perform some service ontheir behalf which involves delegating some decision-making authority to the

Figure 4.1. Contingency factors for outsourcing decisions

Outsourcing Decision

Valuable Rare

Environment Relations

Transaction Costs

Resource Dependence

Resource Base Resource-based theory of the firm

Resource dependence theory

Transaction cost

theory

Agency Costs Monitoring Bonding

Agency theory

Negotiating Enforcing



agent. Agency costs in terms of monitoring, bonding, and residual loss increasein outsourcing relationships with high uncertainty, high-risk aversion, low pro-grammability, low outcome measurability, and greater length of relationship.

• Transaction costs are based on transaction cost theory that maintains that theorganization of economic activity depends on balancing production economics,such as scale, against the cost of transacting. Transaction costs in terms ofnegotiating, monitoring, and enforcing contracts increase in outsourcing relation-ships by lower asset specificity, higher uncertainty, and lower frequency ofcontracting.

Activity-Based Theory of the Firm

The resource-based theory of the firm grew out of efforts to explain the growth of firms.Although its origins lay primarily in economics, researchers in strategy have developedthe resource-based theory. The main attraction of the resource-based theory is that itfocuses on explaining why firms are different and its effect on profitability. The maintenets of the resource-based theory are that firms differ in their resource endowmentsthat these differences are persistent, and that firm-level performance differentials can beexplained by analyzing a firm’s resource position. Differences in resources are seen tolead to nonreplicable efficiency rents.Sheehan (2002) discussed comparing and contrasting the resource-based theory with theactivity-based theory, and his discussion is presented in the following. The activity-based theory conceives the firm as a bundle of activities, while the resource-based theoryconceives the firm as a bundle of resources. The resource-based theory focuses onexplaining why firms create more value than others by examining differences in resourcestocks. However, the resource-based theory places little or no emphasis on resourceflows. The role of the production function in transforming inputs into end products (otherthan having the latent ability to transform) is underconceptualized in the resource-basedtheory. On the other hand, the activity-based theory focuses on flows of resources inactivities. It emphasizes the impact of the firm’s production function on creating value,while placing little attention on differences in stocks of resources. It is implicitly assumedthat all necessary inputs (resources) can be acquired from the market.The goal of strategy formulation in the resource-based theory is to identify and increasethose resources that allow a firm to gain and sustain superior rents. Firms owningstrategic resources are predicted to earn superior rents, while firms possessing no or fewstrategic resources are thought to earn industry average rents or below-average rents.The goal of strategy formulation in the activity-based theory is to identify and exploredrivers that allow a firm to gain and sustain superior rents. Drivers are a central conceptin the activity-based theory. To be considered drivers, firm-level factors must meet threecriteria: they are structural factors at the level of activities, they are more or lesscontrollable by management, and they impact the cost and/or differentiation position ofthe firm. The definition of drivers is primarily based on what drivers do. Drivers areabstract, relative, and relational properties of activities. For example, scale of an activityis a driver, as the size of the activity relative to competitors may represent a competitiveadvantage.



The analytical focus of the resource-based theory is potentially narrower than that of theactivity-based theory. While the activity-based theory takes the firm’s entire activity setas its unit of analysis, the resource-based theory focuses on individual resources orbundles of resources. Having a narrower focus means that the resource-based theorymay not take into account the negative impact of resources, how a resource’s value maychange as the environment changes, or the role of noncore resources in achievingcompetitive advantage.The activity-based and resource-based theories are similar as they both attempt toexplain how firms attain superior positions through factors that increase firm differen-tiation or lower firm cost. While drivers and resources share a common goal of achievingand sustaining superior positions, the manner by which they are seen to reach a profitableposition is different. With the resource-based theory it is the possession or control ofstrategic resources that allow a firm to gain a profitable position. On the other hand,drivers within the activity-based theory are not unique to the firm. They are generic,structural factors, that are available to all firms in the industry, in the sense that they areconceptualized as properties of the firm’s activities. A firm gains a profitable position byconfiguring its activities using drivers. It is this position that a firm may own, but onlyif it is difficult for rivals to copy the firm’s configuration.The sustainability of superior positions created by configuring drivers or owningresources is based on barriers to imitation. The sustainability of competitive advantageper the activity-based theory is through barriers to imitation at the activity level. If thefirm has a competitive advantage, as long as competitors are unable to copy the wayactivities are performed and configured through the drivers, the firm should be able toachieve above-average earnings over an extended period. The sustainability of superiorprofitability in the resource-based theory is through barriers to imitation of resources andimmobility of resources. If resources are easily copied or substituted, then the sustainabilityof the position is suspect.Sheehan (2002) concludes his discussion by finding similarities between the resource-based theory and the activity-based theory. Resources in the resource-based theory aresimilar to drivers in the activity-based theory as both are based on earning efficiencyrents. Furthermore, capabilities in the resource-based theory are similar to activities inthe activity-based theory as both imply action.

Partnership and Alliance Theory

Partnership appears to be a less rigorously defined analytical framework than the theoriesof core competencies, transaction cost economics, and agency. Indeed, the very word“partnership” has a more everyday ring to it and is associated with the readily understoodcharacteristics, which may be found in a relationship between two or more parties in aparticular context. Partnership’s treatment in the IS literature seems largely nontheoretical,perhaps reflecting a wide diversity of practical arrangements and the absence of a singlecommonly recognized theory. Although the sharing of risk and reward is sometimesmentioned in the IS literature, often the emphasis is on intangibles, such as trust; comfort;



understanding; flexibility; cooperation; shared values, goals, and problem solving; goodinterpersonal relation; and regular communication. The influential Kodak-IBMoutsourcing deal had much to do with a sense of honor and a chemistry between theparties, and changed the common perception of IT outsourcing from an arm’s-lengthrelationship to one of strategic partnership (Hancox & Hackney, 2000).Partnership, often referred to as an alliance, has frequently been noted as a major featureof IT outsourcing. Partnership can reduce the risk of inadequate contractual provision,which may be comforting for clients about to outsource a complex and high-cost activitysuch as IT. However, in the relationship between vendor and client, the latter may beoverdependent on the former, and goals are not necessarily shared. A client may be morecomfortable if it knows the vendor already. In partner selection, cultural compatibility isvital and shared values and objectives inform all stages of the partnership developmentprocess. This may make a successful relationship especially difficult if the putativepartners are from fundamentally different domains and bring fundamentally differentperspectives, as might well be argued is the case in a private sector–public sectorarrangement. The difficulty may be compounded where, as in the U.K. government’scompulsory competitive tendering policy, the outsourcing can be involuntary.Hancox and Hackney (2000) found that few organizations claim to be in a strategicpartnership with their IT suppliers. The contract is more likely to favor the vendorbecause he has greater experience in negotiation. Clients with loose contracts were morelikely to regard outsourcing as a failure; yet, most respondents in a study used thevendor’s standard contract as a basis for outsourcing agreement and most did not useexternal technical or legal advice. It was found that 80% of clients wished that they hadmore tightly defined contracts. Partly the client’s view of IT influences its relationshipwith the vendor, such that firms regarding IT as a core competence capability are morelikely to look upon outsourcing as an alliance. Clients who view IT as a core are also morelikely to be satisfied with the outsourcing arrangements because they negotiate from amore knowledgeable position.Hancox and Hackney (2000) interviewed IT managers to find support for the partnershiptheory in IT outsourcing. Despite assurances found in vendors’ marketing literature,most clients were skeptical about partnership. If partnership did exist, it was usually asa collection of some of the intangibles mentioned earlier, rather than as a formalizedarrangement. Partnership was more likely to be claimed in the area of systems develop-ment, where vendors needed to have a greater understanding of the organization, thanin outsourcing of operations and IT infrastructure support. There seemed to be nocorrelation between those organizations regarding IT as strategic and those regardingrelationships with vendors as partnerships.Das and Teng (2002b) studied how alliance conditions change over the different stagesof alliance development to understand the development processes of strategic alliancessuch as an IT outsourcing relationship. They defined the following stages in the alliancedevelopment process:

• Formation Stage. Partner firms approach each other and negotiate the alliance.Partner firms then carry out the agreement and set up the alliance by committingvarious types of resources. The alliance is initiated and put into operation.



Alliances will be formed only under certain conditions. These conditions includea relatively high level of collective strengths, a low level of interpartner conflicts,and a high level of interdependencies.

• Operation Stage. Not only is the formation stage directly influenced by allianceconditions, but the transition from the formation stage to the operation stage is alsodictated by the same alliance condition variables. During the operation stage,partner firms collaborate and implement all agreements of the alliance. The alliancewill likely grow rapidly in size during this stage, somewhat akin to the growth stageof organizational life cycles. Other than the growth route, an alliance may also bereformed and/or terminated at this stage.

• Outcome Stage. During this stage, alliance performance becomes tangible and can,thus, be evaluated with some certainty. There are four possible outcomes for analliance at this stage: stabilization, reformation, decline, and termination. A com-bination of outcomes is also possible, such as a termination after reformation.Alliance reformation and alliance termination do not necessarily signal alliancefailure. Reformation and termination may be the best option under certain circum-stances, such as the achievement of preset alliance objectives. Alliance conditionvariables continue to play a decisive role in the outcome stage. The particularalliance outcome will depend on the condition of the alliance.

Das and Teng (2003) discussed partner analysis and alliance performance. An importantstream of research in the alliance literature is about partner selection. It emphasizes thedesirability of a match between the partners, mainly in terms of their resource profiles.The approach is consistent with the resource-based theory of the firm, which suggeststhat competitors are defined by their resources profiles. They found a lack of agreementconcerning alliance performance. This lack of agreement reflects an underlying concep-tual puzzle: what does effective alliance performance mean? There are two distinct lociof alliance performance in the literature: the alliance itself and the partners forming thealliance. On the one hand, when alliances are viewed as separate entities, allianceperformance is the success of these separate entities, in terms of, say, profitability orgrowth rate. On the other hand, because partner firms use alliances to achieve certainstrategic objectives, alliance performance ought to be measured in terms of the aggre-gated results for the partner firms.Alliances are broadly defined as collaborative efforts between two or more firms in whichthe firms pool their resources in an effort to achieve mutually compatible goals that theycould not achieve easily alone. Resources here are defined as any tangible or intangibleentity available for use by a firm to compete in its marketplace. When interfirm businessrelationships are collaborative rather than adversarial in nature, a variety of types ofthese relationships may be classified as alliances, for example, outsourcing. Accordingto Lambe, Spekman, and Hunt (2002a), the popularity of alliances is growing. Alliancesaccount for anywhere from 6% to 25% of the market value of the typical company. Yetalliance success remains elusive. Studies find that as many as 70% of alliances are notsuccessful. Thus, an important question for researchers and practicing managers is,“What makes alliances succeed?” They argue that alliance competence contributes toalliance success, both directly and through acquisition and creation of resources. Using



survey data gathered from 145 alliances, empirical tests provide support for the positedexplanation of alliance success.Alliance competence has three facets, which Lambe et al. (2002a) labeled allianceexperience, alliance manager development capability, and partner identification propen-sity. Furthermore, consistent with competence-based theory and resource-advantagetheory conceptualizations of a competence (a higher order resource that is a distinctcombination of lower order resources), the researchers proposed that these three facetsare the three lower-order resources that collectively comprise the higher-order resourceof an alliance competence. That is, more of each of these three lower-order resources willcontribute to increasing a firm’s competence in finding, developing, and managingalliances:

• Alliance experience is a resource that can be leveraged across an organizationbecause it contributes to knowledge about how to manage and use alliances.

• Alliance manager development capability enables firms to plan and navigate themechanisms of an alliance so that roles and responsibilities are clearly articulatedand agreed upon. In addition, these managers have the ability to review continuallythe fit of the alliance to the changing environment to make modifications asnecessary.

• Partner identification propensity enables firms to systematically and proactivelyscan for and identify partners that have the complementary resources that areneeded to develop a relationship portfolio or mix that complements existingcompetencies and enables them to occupy positions of competitive advantage.

Lambe et al. (2002a) posited that two specific types of resources affect alliance success:idiosyncratic and complementary resources. In terms of resource-advantage theory,complementary resources may be thought of as lower-order resources that are broughtto the alliance and idiosyncratic resources as the higher-order resources that aredeveloped by the alliance through the process of combining the complementary re-sources of the partner firms. Idiosyncratic resources are resources that are developedduring the life of the alliance, are unique to the alliance, and facilitate the combining ofthe distinct lower-order resources contributed by the partner firms. Idiosyncraticresources may be tangible, such as computers and cables, or intangible, such asdeveloping a methodology or a process together. Similarly, some researchers refer toidiosyncratic investments or assets.

Relational Exchange Theory

Contracts are often extremely imperfect tools for controlling opportunism. While rela-tional contracts may mitigate some opportunistic behavior, significant residual oppor-tunism may remain. It is possible that transactors using relational contracts may incursignificant ex post bargaining costs as they periodically negotiate contract adjustments



(Artz & Brush, 2000). Relational exchange theory is based on relational norms. Accordingto this theory, the key to determining how efficiently contract governance is carried outlies in the relational norms between the transactors. For example, the degree to whichtransactors engage in joint planning or their extent of interfirm information sharing, areprocess elements that determine the costs associated with periodically renegotiatingcontracts. Those transactors who have established behavioral norms that can simplifyand smooth the renegotiation process can reasonably expect to incur lower ex postbargaining costs than those who have not.Artz and Brush (2000) examined supplier relationships that were governed by relationalcontracts, and they found support for the relational exchange theory. By altering thebehavioral orientation of the alliance, relational norms lowered exchange costs. In theirmeasurement of relational norm, Artz and Brush included collaboration, continuityexpectations, and communication strategies. Collaboration refers to the willingness ofthe client and vendor to work together to create a positive exchange relationship andimprove alliance performance. Collaborative actions can act to enhance the client–vendor relationship as a whole and curtail opportunistic behaviors. For example, jointplanning and forecasting can allow both the customer and the supplier to participate indetermining each roles and responsibilities and foster mutually beneficial expectations.Continuity expectations refer to the extent to which the customer and the supplier expectthe relationship to continue for the foreseeable future. Expectations of a long-term supplyrelationship can encourage cooperation by providing the opportunity for one alliancepartner to retaliate if the other behaved opportunistically. Specifically, opportunisticbehavior by one party in one period can be matched by opportunistic behavior by theother partner in the next. Similarly, cooperation can be met with cooperation. Communi-cation strategies refer to the type of communications the customer and vendor use in theirbargaining sessions to try to influence the negotiations. Such strategies can be groupedinto either coercive or noncoercive communications. Partners using coercive communi-cations attempt to achieve their desired goals by applying direct pressure with adverseconsequences of noncompliance stressed. Examples of coercive communications in-clude using threats or legalistic pleas, in which one party argues that compliance isrequired by the formal contract terms. When one firm attempts to coerce another in orderto gain a more favorable negotiation outcome, that firm is likely to be viewed by its alliancepartner as exploitative rather than accommodative, and retaliatory behavior often results.In contrast, noncoercive strategies attempt to persuade rather than demand. Noncoercivecommunications center on beliefs about business issues and involve little directpressure. Examples include simple requests or recommendations in which one partystresses the benefits the other party will receive by complying.Kern and Blois (2002) considered the role of norms within networks by describing howBP Exploration outsourced its information technology function—a major businessactivity. This outsourcing venture led to the formation of a consortium of vendors.However, this attempt was found to have failed. They suggested that central to the failureof the consortium, as an outsourcing arrangement was the issue of norms. Norms createexpectations of behavior and imply a certain action and are shared by the actors. It isbelieved that society shares a number of common norms that make it necessary forcontracts to contain certain features but not necessary to include statements aboutothers. Yet norms vary a great deal between and within societies as is illustrated by



international contracts where a foreigner’s requirements as to what should go into acontract will often surprise us but what we would not consider necessary to include maysurprise them.Businesses recognize the impossibility of a contract meeting every eventuality so thatthere is a need for adaptability within a contract and the completion of a contract isfrequently dependent upon workers being able to take up a lot of the uncertainty. Boththe normal economic models of a market transaction and the legal model of a contract tendto obscure the degree to which large numbers of contracts are agreements to deliver anindefinite good or service for an indefinite price. Without such willingness to beadaptable many business relationships would grind rapidly and regularly to a halt. Normsare in a sense the lubricants that keep relationships from being stymied by theircontractual terms.In the case of BP Exploration, three problems arose. First, the consortium’s members,though competitors, were expected to work closely with each other as the senior partneron some sites and as the junior partner on others. Yet neither BP Exploration nor anymember of the consortium recognized in advance that the norms that they usually appliedin their relationships with their clients would not be applicable to this situation.Consequently, their staff was working with norms that were at best not appropriate tothe new situation and at worst made for difficulties. For example, a company’s norms donot normally encourage the acceptance of flexibility, information exchange, and solidar-ity in contacts with competitors, all of which are needed if sound relationships are to bedeveloped between organizations. Second, BP Exploration’s line managers conductedtheir relationships with the consortium members as if they were buying a commodityservice. Yet a major reason for outsourcing was BP Exploration’s desire to obtain a state-of-the-art IT service. Its behavior toward the consortium was therefore based on normsthat were inappropriate relative to its stated objectives. The third problem was that oneof the vendors was not familiar with European modes of operations and had a horrendousjob trying to adapt to a non-U.S. culture.Norms are formed in different ways. Some norms’ roots can be related to culturalbackgrounds, but the roots of others are more difficult to identify. However, how normsdevelop when new industries or, as in the case of BP, new forms of organization evolveis far from apparent. In relationships such as the one described in this case, whichdevelop in a new environment, the relative power of the parties involved is presumablya major factor. Thus, where one organization is very dominant in a new market, it seemsprobable that their values and approaches to business will be very influential. Withinbusiness relationships the nature of exchanges that occur between the personnelinvolved can vary a great deal. Sometimes the relationships at a senior level are morerelaxed than those at a junior level. Yet the opposite can be true with junior staff makingthe relationship work on a day-to-day level in spite of adversarial behavior between thedirectors. Many classifications of norms have been proposed, but no one is regarded asdominant. It has been proposed that relational norms are a higher order constructconsisting of three dimensions (Kern & Blois, 2002):

• Flexibility, which defines a bilateral expectation of the willingness to makeadaptations as circumstances change.



• Information exchange, which defines a bilateral expectation that parties willproactively provide information useful to the partner.

• Solidarity, which defines a bilateral expectation that a high value is placed on therelationship. It prescribes behaviors directed specifically toward relationshipmaintenance.

Many factors led to BP Exploration being a less-than-successful experiment in outsourcing.However, a major contribution was a failure to recognize the need for establishing normsof behavior that were appropriate to the consortium form of organization (Kern & Blois,2002).Norms are expectations about behavior that are at least partially shared by a group ofdecision makers. Norms are important in relational exchange because they provide thegovernance rules of the game. These rules depend on the game, which from an exchangeperspective has been described as either discrete or relational. Discrete exchange normscontain expectations about an individualistic or competitive interaction between ex-change partners. The individual parties are expected to remain autonomous and pursuestrategies aimed at the attainment of their individual goals. In contrast, relationalexchange norms are based on the expectation of mutuality of interest, essentiallyprescribing stewardship behavior, and are designed to enhance the well-being of therelationship as a whole. In the evolutionary model of relational exchange, relational normdevelopment takes place during an extended period of time through many interactionsbetween the partners. For example, tacit relational norms emerge as partners interactduring the exploration stage of relational development (Lambe, Spekman, & Hunt, 2000).Relational exchange is an interactive process where commitments are made, outcomes areobserved, and further investments are made if outcomes meet or exceed expectations.Based on previous interactions as well as expectations about the future, a mutualorientation develops resulting in a common language and mutual knowledge. Theexchange is embedded in a normative structure that determines the functioning of thesystem. Patterns of behavior are taken for granted. The actors share common expecta-tions about expected and accepted behavior, and collective interests are incorporatedinto the preferences and belief structures of the actors (Rokkan & Haugland, 2002).Discrete and relational exchange can be regarded as polar cases. Pure discrete exchangeis consistent with the underlying assumptions of neoclassical economic theory. Rela-tional exchange, on the other hand, accounts for the social and historical context in whichexchange takes place. The fundamental norms of discrete exchange are discreteness andpresentation, which means that any transaction is separated from all else between theparticipants at the same time and before and after, and that all future obligations andactions are brought into the present. Relational exchange, on the other hand, is basedon norms such as role integrity, conflict resolution, and preservation of the relationship.Rokkan and Haugland (2002) study the effect of power on relational exchange. Power isrelated to whether the relationship is symmetrical or unbalanced. A key characteristic oflong-term relationships is mutual power relations. Actor A’s power in the relationshipwith B is the inverse of B’s dependence upon A. Dependence or interdependence thusaffects and constrains the behavior of the actors, but it may also create opportunities.This factor is important in relation to relational exchange, as it is closely linked to the



question of equity or fair dealing. They hypothesized that dependence asymmetry wouldhave a negative effect on relational exchange, but they did not find empirical support intheir survey for this hypothesis.

Stakeholder Theory

The stakeholder approach to strategic management was introduced by Freeman (1984).According to Freeman a stakeholder is any group or individual who can affect, or isaffected by, the achievement of a corporation’s purpose. Stakeholders include employ-ees, customers, suppliers, stockholders, banks, environmentalists, government, andother groups who can help or hurt the corporation. For each category of stakeholders,groups can be broken down into several useful smaller categories. Freeman’s focus isto show how executives could use the stakeholder approach to manage their organizationmore effectively. In instrumental stakeholder theory, the role of management is seen asachieving a balance between the interests of all stakeholders. For each major strategicissue we must think through the effects on a number of stakeholders, and therefore, weneed processes that help take into account the concerns of many groups. It is argued thatmaintaining an appropriate balance between the interests of all stakeholder groups is theonly way to ensure survival of the firm and the attainment of other performance goals.The normative condition is that managers must provide economic and otherwise returnsto stakeholders in order to continue engaging in wealth-creating activities by virtue ofthe critical resources stakeholders provide to the firm.Stakeholder theory is justified on the basis that firms have responsibilities to stakehold-ers for moral reasons, and that there is no priority of one set of interests over another.Upholding four principles: (1) honoring agreements, (2) avoiding lying, (3) respecting theautonomy of others, and (4) avoiding harm to other, are necessary preconditions forefficient working. And thus, stakeholder theories of the firm establish economic relation-ships within a general context of moral management. Contrary to the traditional under-standing of the principal–agent relationship, used in several IT outsourcing studies, astakeholder orientation will include at least two new dimensions: (1) a number ofstakeholder groups and (2) the interpretation of the four moral principles that underliestakeholder theory. Neglecting these dimensions, firms will have less satisfied stake-holders, and will show financial performance that is consistently below industry average(Shankman, 1999).The term “stakeholder” is a powerful one. This is due, to a significant degree, to itsconceptual breadth. The term means many different things to many different people andhence evokes praise and scorn from a wide variety of scholars and practitioners of myriadacademic disciplines and backgrounds. Such breadth of interpretation, though one ofstakeholder theory’s greatest strengths, is also one of its most prominent theoreticalliabilities as a topic of reasoned discourse. Much of the power of stakeholder theory isa direct result of the fact that, when used unreflectively, its managerial prescriptions andimplications are merely limitless. When discussed in instrumental variation (i.e., thatmanagers should attend to stakeholders as a means to achieving other organizational



goals such as profit or shareholder wealth maximization) stakeholder theory standsvirtually unopposed. Stakeholder theory is a theory of organizational management andethics. Indeed all theories of strategic management have some moral content, though itis often implicit. Moral content in this case means that the subject matter of the theoriesis inherently moral topics (i.e., they are not amoral). Stakeholder theory is distinctbecause it addresses morals and values explicitly as a central feature of managingorganizations. The ends of cooperative activity and the means of achieving these endsare critically examined in stakeholder theory in a way that they are not in many theoriesof strategic management (Phillips, Freeman, & Wicks, 2003).Managing stakeholders involves attention to more than simply maximizing shareholderwealth. Attention to the interests and well-being of those who can assist or hinder theachievement of the organization’s objectives is the central admonition of the theory. Inthis way, stakeholder theory is similar in large degree with alternative models of strategicmanagement, such as resource-based theory. However, for stakeholder theory, attentionto the interests and well-being of some nonshareholders is obligatory for more than theprudential and instrumental purposes of wealth maximization of equity shareholders.While there are still some stakeholder groups whose relationship with the organizationremains instrumental (due largely to the power they wield) there are other normativelylegitimate stakeholders than simply equity shareholders alone. According to Phillips etal. (2003), stakeholder theory may be undermined from at least two directions—criticaldistortion and friendly misinterpretations—at its current stage of theoretical develop-ment. Critical distortions include arguments that stakeholder theory is an excuse formanagerial opportunism and that stakeholder theory cannot provide sufficiently specificobjective function for the corporation. Friendly misinterpretations include argumentsthat stakeholder theory requires changes to current law and that stakeholder theory issocialism and refers to the entire economy.According to Phillips et al. (2003), it is commonly asserted that stakeholder theory impliesthat all stakeholders must be treated equally irrespective of the fact that some obviouslycontribute more than others to the organization. Prescriptions of equality have beeninferred from discussions of balancing stakeholder interests and are in direct conflictwith the advice of some experts on organizational design and reward systems. However,corporations should attempt to distribute the benefits of their activities as equitably aspossible among stakeholders in light of their respective contributions, costs, and risks.This interpretation of balance is called meritocracy, where benefits are distributed basedon relative contribution to the organization. In addition to meritocracy, it has beensuggested that stakeholders may usefully be separated into normative and derivativestakeholders. Normative stakeholders are those to whom the organization has a directmoral obligation to attend to their well-being. They provide the answer to seminalstakeholder query “For whose benefit ought the firm be managed?” Typically normativestakeholders are those most frequently cited in stakeholder discussions such asfinanciers, employees, customers, suppliers, and local communities. Alternatively,derivative stakeholders are those groups or individuals who can either harm or benefitthe organization, but to whom the organization has no direct moral obligation asstakeholders. This latter group might include such groups as competitors, activists,terrorists, and the media. The organization is not managed for the benefit of derivativestakeholders, but to the extent that they may influence the organization or its normative



stakeholders, managers are obliged to account for them in their decision making. Far fromstrict equality, therefore, there are a number of more convincing ways that stakeholdertheory may distinguish between and among constituency groups.Stakeholder theory is a managerial conception of organizational strategy and ethics. Thecentral idea is that an organization’s success is dependent on how well it manages therelationships with key groups such as customers, employees, suppliers, communities,financiers, and others that can affect the realization of its purpose. The manager’s jobis to keep the support of all of these groups, balancing their interests, while making theorganization a place where stakeholder interests can be maximized over time. Theidentification of stakeholder groups is currently among the central debates in thescholarly and popular (Freeman & Phillips, 2002).Lacity and Willcocks (2000a) define a stakeholder as a group of people with alignedinterests. The term is widely used and accepted by IT outsourcing practitioners andresearchers. However, as indicated by some of the reviewed literature above, stakeholderis defined and used differently in finance (issue of CEO responsibility to shareholdersor stakeholders), law (requires ownership), and gaming (person who holds the bets).According to Lacity and Willcocks (2000a), there are four distinct client IT stakeholdergroups and three distinct supplier IT stakeholder groups. The groups identified arecustomer senior business managers, customer senior IT managers, customer IT staff,customer IT users, and supplier senior managers, supplier account managers, andsupplier IT staff. An additional group is the subcontractors. All stakeholder groups arepresumed to have significant differences in expectations and goals regarding IToutsourcing. Thus, it is reasonable to propose that upholding the interest of thesedifferent stakeholder groups with the principles of moral management will affect thesuccess of IT outsourcing.

Theory of Firm Boundaries

There has been renewed debate on the determinants of firm boundaries and theirimplications for performance. According to Schilling and Steensma (2002), the widelyaccepted framework of transaction cost economics has come under scrutiny as acomprehensive theory for firm scale and scope. At the heart of this debate is whether theunderlying mechanism determining firm boundaries is a fear of opportunism (as positedby transaction cost economics), a quest for sustainable advantage (as posed byresource-based view theorists and others), a desire for risk-reducing flexibility (as hasrecently gained increased attention in work on options), or a combination of factors.Although perspectives on firm boundaries such as transaction costs or the resource-based view are based on fundamentally different motivations for pursuing hierarchicalcontrol over market contracts, they rely on common resource or context attributes asantecedents.Schilling and Steensma (2002) explore how various attributes of technology to be sourcedinfluence the governance mode chosen, and the intermediate mechanisms by which theydo so. They found that uniqueness and difficulty of imitation are significantly related to



the perceived potential for sustainable advantage. They also found that technologicaldynamism and difficulty of imitation are significantly related to the perceived threat ofopportunism. In turn, consistent with a transaction cost perspective, the threat ofopportunism increases the probability of outsourcing. Schilling and Steensma’s findingssuggest that the resource-based view, transaction cost economics, and an optionsperspective may play complementary roles in explaining firm technology-sourcingdecisions. Firms may pursue resources that are unique or inimitable because of theirpotential to create a sustainable competitive advantage, but the uniqueness andinimitability may also create a potential for opportunism. The potential for opportunismand the degree of uncertainty associated with the technological resources then heavilyinfluence the governance mode chosen. In sum, the results imply that the resource-basedview explains why a firm pursues particular resources rather than others, but transactioncosts and an options perspective better explain the governance mode undertaken foraccessing the resources once they are chosen.Therefore, the theory of firm boundaries claims that the resource-based view, transactioncosts, and options perspectives each explain only a portion of managerial motivation fordecisions on firm boundaries. The rationale supporting the choices firms make regardingtechnology sourcing is multidimensional; firms are not only seeking potential sourcesof competitive advantage, but are also seeking to avoid opportunism and to preserve orcreate flexibility (Schilling & Steensma, 2002).Afuah (2003) presents two models for exploring the impact of the emergence and diffusionof the Internet on vertical and horizontal firm boundaries. He argues that the effect of theemergence and diffusion of the Internet on a firm’s boundaries is a function of the firm’sdeterminants of costs, moderated by the information dependence and tacitness of thefirm’s value-adding activities and the organizational technology that underpins thefirm’s primary activities. His models suggest that the emergence and diffusion of theInternet should also expand some firm boundaries. To understand the impact of theemergence and diffusion of the Internet on firm boundaries, Afuah identifies determi-nants for firm boundaries. In converting inputs to outputs, an organization must oftendecide which ones to buy from an external supplier. It must also decide which outputsto dispose of itself and which ones to have someone else dispose of. These decisionsdetermine a firm’s vertical boundaries. Once it has decided on its vertical boundaries, itmust also choose the scale and scope of activities to perform—that is, it must decide whatits horizontal boundaries should be.Afuah (2003) finds that the literature on vertical firm boundaries can be divided into twoperspectives. In the first, researchers argue that firms decide to organize activitiesinternally or through markets for efficiency reasons. In the second, researchers arguethat firms decide to organize activities internally or through markets for strategicpositioning reasons. Since the Internet’s largest potential is in reducing costs, Afuahfocused only on the first perspective to keep the arguments traceable. Thus, the decisionto outsource or to develop an input internally depends on weighing external componentproduction and transaction costs, on the one hand, and internal component productionand transaction costs, on the other hand. If the former are greater than the latter, a firmis better off integrating vertically backward to produce the input internally. Horizontalfirm boundaries is a function of the extent to which its activities exhibit economies ofscale—that is, the extent to which its systems production costs per unit fall as its output



production volume increases. Usually, as a firm expands, its unit production costs(average costs) decrease. At the same time, the bureaucratic costs of coordinating theactivities of the firm also increase. At some quantity, the unit costs start to increase asthe bureaucratic costs of coordinating the activities of the larger organization becomegreater than the decrease in per unit cost from producing more units. Thus, whether theemergence and diffusion of the Internet expands or shrinks firm boundaries horizontallyis a function of its influence on the quantity, which itself depends on the impact on thedeterminants of systems production costs and bureaucratic coordination costs.While Afuah studied impacts on firm boundaries from the Internet, Hitt (1999) studiedimpacts on firm boundaries from IT generally. Previous work has suggested that theeffect of IT on coordination should lead to a change in firm boundaries. Hitt used thesearguments to motivate a test of the relationship between IT and firm boundaries and usethe results of this test to make inferences about the effect of IT on coordination costs.His results suggest a strong negative relationship between IT and vertical integrationand a weaker positive relationship between IT and diversification. This supported hishypothesis that IT is associated with decreases in internal and external coordinationcosts, and that the effect of IT on external coordination costs is stronger and moreconsistent. This also provides evidence supporting previous theoretical analyseslinking IT to changes in firm boundaries, and indicates the utility of the coordination costapproach for evaluating the effect of IT on large-scale organizational structure.A large theoretical literature focuses on the question, “What determines firms’ bound-aries?” One branch of this literature proposes that firms’ boundaries reflect organiza-tional responses to incentive problems associated with specific investments in physicalor human capital. Much of the existing empirical literature on firms’ boundaries testspropositions derived from this branch of theory. Researchers have found evidenceconsistent with these propositions in a wide variety of procurement contexts. Garicanoand Hubbard (2003) suggest that more recently, some theorists have proposed that firms’boundaries reflect the division of labor across individuals. Whether a set of tasks isorganized within one or multiple firms depends on the extent to which individualsspecialize. While the particular trade-offs these theories emphasize differ from eachother, together they represent a departure from the earlier literature: there is far lessemphasis on specificity and far greater emphasis on issues related to the division of laborsuch as specialization and job design. This class of theories is important because it hasthe potential to explain firms’ boundaries in a wide range of contexts where specificityis unlikely to have an important effect on individuals’ incentives.Firm boundaries—defined as the scope of revenue-sharing arrangements across indi-viduals—reflect trade-offs associated with referral problems, which are problems ofmatching economic opportunities to individuals’ efficiency. The idea is that individualswith specialized skills sometimes have private information about economic opportunitiesfor which others have a comparative advantage in exploiting. This can happen, forexample, when a client with a legal problem involving corporate law approaches a taxlawyer. Incentive problems arise because private information about such opportunitiesis valuable, and transferring them involves adverse selection problems. In contrast, it hasbeen proposed that firms’ boundaries reflect trade-offs associated with multitaskingproblems, which are problems associated with inducing individuals to allocate effortacross tasks efficiently. If incentive instruments are imperfect, giving individuals strong



incentives—for example, by giving them ownership of physical assets —may lead themto allocate their effort across tasks inefficiently (Garicano & Hubbard, 2003).Both of these theories emphasize relationships between the division of labor and firms’boundaries. One of the oldest ideas in economics is that returns to specialization increasewith market size. In our case of IT outsourcing, firms’ boundaries are determined by theextent to which there are large markets for specialization. If there are large markets for ITservices available from vendors, then a client company will tend to outsource more of itsinternal IT function.

Social Exchange Theory

Social exchange theory was initially developed to examine interpersonal exchanges thatare not purely economic. Several sociologists are responsible for the early developmentof this theory. These theorists view people’s social behavior in terms of exchanges ofresources. The need for social exchange is created by the scarcity of resources,prompting actors to engage one another to obtain valuable inputs. Social exchange canbe defined as voluntary actions of individuals that are motivated by return they areexpected to bring and typically in fact bring from others. Social exchange can be viewedas an ongoing reciprocal process in which actions are contingent on rewarding reactionsfrom others. There are important differences between social exchanges and economicexchanges. Social exchanges may or may not involve extrinsic benefits with objectiveeconomic value. In contrast to economic exchanges, the benefits from social exchangesoften are not contracted explicitly, and it is voluntary to provide benefits. As a result,exchange partners are uncertain whether they will receive benefits. Thus social exchangetheory focuses on the social relations among the actors that shape the exchange ofresources and benefits. While its origins are at the individual level, social exchangetheory has been extended to organizational and interorganizational levels (Das & Teng,2002a). Social exchanges can be either restricted or generalized. Restricted socialexchange occurs when two parties directly exchange favors with each other, which is alsoknown as dyadic or mutual exchange. In contrast, generalized social exchanges take placeamong a group of at least three parties, and there is no direct reciprocity among them.In other words, what A receives from B is not contingent upon what A gives B. Typically,an IT outsourcing relationship will be a restricted social exchange.Social exchange theory can be traced to one of the oldest theories of social behavior—any interaction between individuals is an exchange of resources. The resources ex-change may be not only tangible, such as goods or money, but also intangible, such associal amenities or friendship. The basic assumption of social exchange theory is thatparties enter into and maintain relationships with the expectation that doing so will berewarding (Lambe, Wittmann, & Spekman, 2001).Social exchange theory postulates that exchange interactions involve economic and/orsocial outcomes. Over time, each party in the exchange relationship compares the socialand economic outcomes from these interactions to those that are available from exchangealternatives, which determines their dependence on the exchange relationship. Positiveeconomic and social outcomes over time increase the partners’ trust of each other and



commitment to maintaining the exchange relationship. Positive exchange interactionsover time also produce relational exchange norms that govern the exchange partners’interactions. Implicit in these postulates, the four foundational premises of socialexchange theory are (1) exchange interactions result in economic and/or social outcomes,(2) these outcomes are compared over time to other exchange alternatives to determinedependence on the exchange relationship, (3) positive outcomes over time increase firms’trust of their trading partner(s) and their commitment to the exchange relationship, and(4) positive exchange interactions over time produce relational exchange norms thatgovern the exchange relationship (Lambe et al., 2001).Commitment is a widely used construct in social exchange research. It has been definedas an exchange partner believing that an ongoing relationship with another is soimportant as to warrant maximum efforts at maintaining it; that is, the committed partybelieves the relationship is worth working on to ensure that it endures indefinitely.Satisfaction with the exchange relationship is an often-used variable in social exchangeresearch. Satisfaction can be defined in terms of performance satisfaction, which is thelevel in which a transaction meets the expectations of the partners including product andnonproduct attributes. Satisfaction can result from evaluating all aspects of a workingrelationship. Satisfaction/dissatisfaction is a state reflecting a feeling of being rewardedadequately or inadequately for contributions to the relationship. Satisfaction can be theoverall approval of an outsourcing arrangement. Satisfaction has been used in researchas an operationalization of the success of the exchange relationship. According to socialexchange theory, satisfaction plays an integral role in relationships. Firms that receivebenefits that meet or exceed their expectations and are equal to or superior to outcomesavailable from alternatives are likely to maintain and expand the relationship. Satisfactionserves as a measure of a firm’s view of the outcomes of the relationship. While it may notcapture a partner’s estimation of available alternatives, it does provide insight into arelationship’s overall performance (Lambe et al., 2001).An exchange perspective places the study of international relations, such as globaloutsourcing, in a framework of negotiations. Central to this perspective are issues ofequivalence (fairness) and contingency (responsiveness). The challenge for interna-tional actors is to define a precise medium for exchange. The more precise the medium,the less likely actors will misperceive each other’s move. But the more precise the medium,the less likely will actors explore their relationships. Druckman (1998) contrasted thefunction of exchange processes for regulating relationships to problem-solving pro-cesses that can lead to changed (and improved) relationships. He discussed this contrastin terms of calculating actors, the universality of the reciprocity norm, and alternativeconceptions of exchange processes. Based on this discussion, it can be argued that afirm-but-flexible strategy is best for continuing cooperation.When tension arises in international relationships, one approach is called graduated andreciprocated initiative in tension reduction. An interesting feature of this approach is theidea of taking a unilateral initiative or mismatching moves (cooperating after the otherhas competed) taken by the adversary. The effectiveness of conciliatory initiatives forbreaking out of the sorts of conflict spirals has been documented in research studies.Further, the studies have identified conditions under which the strategy is more or lesslikely to work. For example, it was found that initiatives are likely to be more effective whenthe message accompanying the action is clear, when there are no bureaucratic conflicts



concerning the response to the initiative, and when the target of an initiative perceivesno risks to its security. On the other hand, when the target of an initiative is more powerfulthan the initiator and has exploitative aims the initiative is less likely to induce coopera-tion (Druckman, 1998).Social exchange theory assumes self-interested actors who transact with other self-interested actors to accomplish individual goals that they cannot achieve alone. Self-interest and interdependence are central properties of social exchange. Whether it is twolovers who share a warm and mutual affection, or two corporations who pool resourcesto generate a new product, or two companies—a vendor and a client—who enter into along-term outsourcing relationship, the basic form of interaction remains the same. Twoor more actors, each of whom has something of value to the other, decide whether toexchange and in what amounts. Such actors are normally viewed as unemotional beingsthat have information, cognitively process it, and make decisions concerning the patternand nature of exchange with others. Lawler and Thye (1999) explored how emotions canbe brought into social exchange theory. A close examination of many common exchangerelations suggest to them that emotions both enter and pervade social exchangeprocesses. Friendship relations are often propelled by strong affection or feelings of joy;corporate mergers may result from fear or anger; economic partnership may thrivebecause they produce positive feelings such as confidence or pleasure. The context ofexchange may have a discernible emotional tone, invoke particular emotion rules, andgenerate corrective measures when emotions surface or are expressed. The processes ofexchange may cause individuals to feel good, satisfied, relieved, and excited. Theoutcome of social exchange may generate pride or shame directed at one’s self or angeror gratitude directed toward the other. Lawler and Thye (1999) believe that emotionaldynamics have a more central role in social exchange than typically assumed. They definean emotion as a relatively short-lived positive or negative evaluative state that hasneurological and cognitive elements. Emotions are internal states that are not under thecomplete control of actors.Lawler and Thye (1999) identified six approaches that capture key elements of theexchange context, exchange process, and exchange outcomes. These elements hangtogether in a systematic way as shown in Figure 4.2. Within the exchange context,structural-relational conditions are fundamental causes of emotions actually felt andemotion norms shape their expression or display. Within the exchange process, emotions

Figure 4.2. Where emotions enter the exchange process (Lawler & Thye, 1999)

Social Attributions

Social Cohesion

Emotion Norms

(expectations)

Power/ Status

Conditions

Emotion Signals

Cognitive Adjustments

Exchange Context

Exchange Process

Exchange Outcomes



have signaling functions for self and for others, and they may bias how members perceiveone another in present and future interaction. Exchange outcomes, such as frequencyand nature of exchange, generate another layer of emotions that can increase or decreasesocial cohesion when the emotions are attributed to exchange relations, networks, andgroups.

Comparison of Theories

We have introduced 11 theories concerned with outsourcing. In Figure 4.3, these theoriesare compared in terms of what they recommend for outsourcing. We find that sometheories indicate possibilities for outsourcing (theory of core competencies, resource-based theory, transaction cost theory, neoclassical economic theory, and theory of firmboundaries), while others indicate limitations (contractual theory, partnership andalliance theory, relational exchange theory, social exchange theory, agency theory, andstakeholder theory).Figure 4.4 lists a comparison of the theories when it comes to the next stage. The nextstage is when outsourcing has occurred and both client and vendor want the outsourcingarrangement to be successful. What do the theories tell us? As is visible in Figure 4.4,the theories tell us a lot about what to do to be successful. Each theory providesrecommendations for actions that will contribute to managing successful IT outsourcingrelationships. From different theoretical perspectives, recommendations are made.Taken together, Figure 4.4 represents critical success factors for an outsourcingarrangement.

Business Example: British Aerospace

The outsourcing decision processes at British Aerospace (BA) started during the firm’sfinancial crises in 1992. EDS approached the corporate finance director with an unsolic-ited bid to take IT assets off the balance sheet. Although the EDS offer was attractive,BA felt it needed more information.A full-scale investigation of IT outsourcing commenced. The entire decision processlasted a year and a half and involved the services of outside expertise including lawyers,financial modelers, auditors of the request for proposal (RFP), auditors of the in-houseproposal, and technical experts. In late 1992, the corporate IT director created twoindependent teams, a six-person outsourcing evaluation team and an insourcing team todevelop an in-house proposal.The in-house proposal was not intended to be a bid to compete with other suppliers;rather, it was to inform the company what might be possible internally, and also to provideuseful benchmarking information to use in the discussions with other outsourcingparties.



Figure 4.3. Possibilities and limitations in IT outsourcing based on theories

Theory What should be outsourced? Theory of core competencies All IT functions that is peripheral to the company’s produc-

tion of goods and services for the market. Resource-based theory All IT functions where the company does not have sufficient

strategic resources to perform in a competitive way. Strate-gic resources are unique, valuable, difficult to imitate, ex-ploitable, and difficult to substitute.

Transaction cost theory All IT functions where benefits for the company are greater than the transaction costs. Benefits include increased reve-nues and reduced costs.

Contractual theory Only IT functions where the company can expect and se-cure that vendor and customer will have the same contrac-tual behavior. Common contract behavioral patterns include role integrity, reciprocity, implementation of planning, effec-tuation of consent, flexibility, contractual solidarity, reliance, restraint of power, proprietary of means, and harmonization with the social environment.

Neoclassical economic theory All IT functions that an external vendor can operate at lower costs than the company.

Partnership and alliance theory Only IT functions where the company can expect and se-cure a partnership and alliance with the vendor that imply interdependence between the partners based on trust, com-fort, understanding, flexibility, cooperation, shared values, goals and problem solving, interpersonal relations, and regular communication.

Relational exchange theory Only IT functions where the company can easily develop and secure common norms with the vendor. Norms deter-mine behavior in three main dimensions: flexibility, informa-tion exchange, and solidarity.

Social exchange theory Only IT functions where each of the parties can follow its own self-interest when transacting with the other self-interested actor to accomplish individual goals that it cannot achieve alone and without causing hazards to the other party.

Agency theory Only IT functions where the agent (vendor) and the principal (client) have common goals and the same degree of risk willingness and aversion.

Theory of firm boundaries All IT functions that satisfy several of the other theories, mainly resource-based theory and transaction cost theory.

Stakeholder theory Only IT functions where a balance can be achieved be-tween stakeholders. Stakeholders relevant in IT outsourcing include business management, IT management, user man-agement, and key IT personnel at the client, and business management, customer account management, and key service providers at the vendor.



Figure 4.4. Recommendations for managing successful IT outsourcing relationshipsbased on theories

Theory How to succeed in an outsourcing arrangement Theory of core competencies Capability to define IT needs and ability to manage IT services from

the vendor represent the core competence within IT needed in the client organization to succeed in an IT outsourcing arrangement.

Resource-based theory Capability to integrate and exploit strategic IT resources from the vendor together with own resources to produce competitive goods and services. An example of such a resource is the vendor’s compe-tence in an IT application area where the client has limited experi-ence.

Transaction cost theory Minimize transaction costs by reducing the need for lasting specific IT assets; increase transaction frequency; reduce complexity and uncer-tainty in IT tasks; improve performance measurements; and reduce dependence on other transactions.

Contractual theory A complete IT contract based on information symmetry in a predict-able environment with occurrence adaptation that prevents opportun-istic behavior in an efficient collaborative environment with balance of power between client and vendor, where the contract is a manage-ment instrument that grants decision rights and action duties.

Neoclassical economic theory Capability to integrate and exploit IT services from the vendor to-gether with own services to produce competitive goods and services. An example of such a service is the vendor’s operation of the client’s communication network.

Partnership and alliance theory Develop experience with alliances, develop alliance managers, and develop the ability to identify potential partners.

Relational exchange theory Develop and secure common norms that are relevant to both parties. Norms determine behavior and are mainly concerned with flexibility, information exchange and solidarity. Norms shall secure integration in the relation, which takes place through involvement. Involvement occurs by coordination of activities, adaptation of resources and in-teraction between individuals. The degree of involvement in these three dimensions is called activity link, resource link, and actor link.

Social exchange theory Enable social and economic outcomes in the exchange between cli-ent and vendor such that these outcomes outperform those obtain-able in alternative exchanges. Positive economic and social out-comes over time increase the partners’ trust of each other and com-mitment to maintaining the exchange relationship. Commitment is important, as it is an exchange partner’s belief that an ongoing rela-tionship with another is so important as to warrant maximum efforts at maintaining it.

Agency theory It must be easy and inexpensive for the principal (client) to find out what the agent (vendor) is actually doing. In addition, both outcome-based and behavior-based incentives can be used to reduce and prevent opportunistic behavior.

Theory of firm boundaries The supply of IT services from the organization’s environment should change firm boundaries between the firm that desires the compe-tence (sourcing firm) and the firm having the technology (source firm) in a clear and unambiguous manner. This can be achieved in a strict and rigid division of labor between client and vendor.

Stakeholder theory Create efficient and effective communication with and between stakeholders to secure continued support from all stakeholders, to balance their interests and to make the IT outsourcing arrangement so that all stakeholders achieve their goals.



In December 1992, the outsourcing team sent a request for information to 20 potentialsuppliers. In March 1993, 10 suppliers were invited to a bidders’ meeting. Two weeks later,five suppliers responded with a short proposal and a three-hour presentation. By April,the outsourcing team short-listed three suppliers.In June 1993, BA sent out a complete RFP to the short-listed suppliers. The scope of theRFP included most of the infrastructure, applications development, and applicationssupport. The RFP contained cost estimates for in-scope resources, including almost1,500 IT people. The cost estimates were based on the insourcing proposal.Although BA planned to outsource the majority of applications, BA felt that a suppliercould not provide software cheaper because BA would have to pay its markup. Instead,BA was looking for value-added, such as getting free software from other clients. BAplanned to retain about 300 people for core IT capabilities, including IT strategy, contractadministration, relationship management, and strategic IT systems.After distribution of the RFP, the outsourcing team invited the bidders for on-site tours.In return, the bidders invited BA to visit a number of supplier reference sites. Thesereference sites highlighted the need for BA to define a comprehensive and detailedcontract. In particular, the outsourcing team needed consistent cost data, consistentservice data, including standard service-level agreements for 500 services. BA alsorejected the idea of a partnership, as IT suppliers and customers do not share revenuenor are they responsible for each other’s debts.In July 1993, the three short-listed suppliers submitted their final bids. BA felt that allthree suppliers were committed to winning the bid because they spent a significantamount of time and resources on the bidding process. It was estimated that each supplierhad 30 employees working on each bid, and spent approximately £3 million during theprocess.In August, one supplier was eliminated because its bid was 20% higher than the othertwo suppliers. Ironically, this supplier knew BA the best because of past businessinteractions. The supplier admitted that their bid was high because they simply did notbelieve some of the claims in the RFP. The remaining two external bids and the in-houseproposal were very similar in price (only a 1% difference). The in-house proposal showedthat BA could compete with external suppliers on price, but the suppliers were able todo a number of things that BA could not achieve on its own. Supplies would bear the initialinvestment costs required to implement cost reduction tactics such as data centerconsolidation. Outside auditors noted that initially BA would need to hire 50 people todeliver the savings. But in the end, the insourcing proposal served its purpose ofincreasing BA’s negotiating power. At this stage, the main objective of outsourcingshifted from cost reduction to value-added.From August 1993 to November 1993 the divisions became involved in the evaluation ofthe two remaining bidders. Some of the divisions would not benefit financially fromoutsourcing, and argued against the bids. The corporate IT director forcefully arguedthat the entire IT functionality across all business units had to be placed on the auctionblock to attract an external supplier.CSC won the contract. One reason was that CSC marketed IT outsourcing very hard tothe divisions. CSC answered many tough questions about value-added outsourcing.This decentralized marketing strategy finally sold divisions to CSC. CSC was successful



in winning the bid also because of its expertise in aerospace and its ability to talk businesslanguage.In November 1993, the final report was made and approved at the board level. The nextfour months were spent in due diligence to verify RFP data. CSC could alter their bidduring this time if it found any major missing items from the RFP. Also during this time,service-level agreements (SLAs) were defined for the corporate IT and 14 divisions.

Business Example: North Cape Minerals

North Cape Minerals AS (www.ncm.no) is a leading supplier of industrial minerals to thesteel, glass, and ceramic industry. In 2003, North Cape Minerals AS bought theNorwegian mineral company, AS Olivin, which was merged with North Cape Minerals AS(NCM) by the end of 2004. After the merger, NCM would employ approximately 500 peopleand total revenues would exceed NOK 1 billion.NCM has chosen a supply-chain solution from IBS (www.ibs.no), and Ementor willoperate and host the solution, which also contains office tools and general infrastructure.The new business-system will improve the management of the NCM-group, bothstrategically and operationally. Once implemented it will be easier for NCM to focus onits customers, increase productivity, and reduce costs through efficiency improvement,standardization, and integration of processes in all parts of the value chain. Theimplementation of new supply-chain solution for NCM involves approximately 150 usersin Norway, Sweden, Poland, Germany, and England.The outsourcing solution from Ementor will be delivered from an ASP farm. Thus, NCMdoes not need to build its operating environment, but rather keeps focus on improvingits core business. In addition to the IBS solution, Ementor will deliver office tools as partof the ASP service. This includes MS Office XP, Lotus Domino, Lotus Notes, WinZip,and Acrobat Reader. Ementor ensures the security with virus scanning, thin-clienttechnology, and backup routines and solutions. Ementor will also operate Intel servers,an IBM AS/400 server, printers, plotters, copy machines, and thick clients. Administra-tion of licenses and equipment is also an important part of this outsourcing service. Allservices in this agreement are tightly linked to SLA demands with aggressive penaltymodels if Ementor does not deliver within the agreed SLA.“Infrastructure and operating competency at Ementor is impressive. The service deskand its response time are also very good. The main reason for our choice is the breadthof solutions and services that Ementor offer, and will be important for North CapeMinerals in the future,” says System Manager Guttorm Rimstad at North Cape Minerals(Source: Pieter Spilling, Ementor, e-mail May 21, 2004).



Case Study: A Global Deal

ABB is a leader in power and automation technologies that enable utility and industrycustomers to improve performance while lowering environmental impact. The ABB Groupof companies operates in around 100 countries and employs around 105,000 people.Parent company is located in Switzerland. ABB Group 2003 revenues totaled $18.8 billion.The history of ABB goes back to the late nineteenth century, and is a long an illustriousrecord of innovation and technological leadership in many industries. ElektriskaAktiebolaget was established in Stockholm in 1883 as manufacturers of electrical lightingand generators. Some years later in 1990 a merger founded Allmänna Svenska ElektriskaAktiebolaget, later shortened to Asea. In the beginning of the 1900s Asea played a majorrole in the electrification of Swedish industry, railways, and homes. It expanded itsbusiness internationally and in the 1980s Asea was one of the top 10 companies in theworld in power technologies. In 1986, the year prior to its merger with Brown, Boveri &Cie (BBC), Asea had revenues of Skr 46 billion, and 71,000 employees. BBC wasestablished in Baden, Switzerland, in 1891. Shortly afterward, BBC was the first companyto transmit high-voltage AC power. The company has continued to invent a number ofmajor new technologies such as electrical machines in motors and generators, combus-tion gas turbines for generating electricity, locomotive technology, transformers, andcontrol systems. In 1986, the year prior to its merger with Asea, BBC had revenues of Skr58 billion, and 97,000 employees worldwide. In 1988 Asea and BBC merged to form AseaBrown Boveri Ltd. (ABB), one of the largest electrical engineering companies in theworld. A large-scale program of expansion resulted in several acquisitions in thefollowing years. In 2002 ABB streamlined its divisional structure to focus on two coreareas of business: power technologies and automation technologies. ABB sold itsfinancial services division, its oil, gas, and petrochemicals division, and its buildingsystems business area. A divestment program of noncore business continued in 2003(ABB Group, 2004a, 2004b).By July 28, 2003, ABB and IBM signed a 10-year agreement to outsource close to 90%of ABB’s IS infrastructure operations, including the transfer to IBM of more than 1,200employees. The agreement was valued at US$1.1 billion and built on a well-establishedrelationship between the two companies. The contract was part of ABB’s strategy tofocus on its core industrial businesses and would help ABB significantly reduce costsover the period. Combined with pilot contracts signed in the fourth quarter of 2001 forapproximately US$600 million, the full value of the relationship would approach US$1.7billion over 10 years. IBM Global Services would take responsibility for the operation andsupport of IS infrastructure in 14 countries in Europe and North America—representingsome 90% of ABB’s IS infrastructure. The deal included taking over the management ofservers, operating systems, and corporate networks, personal computers, and helpdesks.Control systems within power and automation technologies were regarded as a part ofABB’s core business. The company had several laboratories developing such industrialIT solutions. Industrial IT solution enabled ABB customers to manage their installationsbetter and to link up in real time with their own suppliers and customers. Standardapplications, such as ERP systems, were not a part of the outsourcing deal. ABB had



largely got control over global IT infrastructure. The environment had a consistentservice specification across ABB countries and a common nomenclature language.Although it was not a heavily standardized environment, ABB had some basic corestandards. It was a well-run infrastructure, and the people providing it were good quality.ABB had defined the infrastructure services that it was providing to the businesses, andthe business area units were used to buying it. ABB had a sophisticated unit chargingservice.

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Chapter V

Enter Strategy

Why does the outsourcing of IT frequently fail to produce the expected cost savings andother benefits? Lacity, Willcocks, and Feeny (1996) pose this question, and they suggestthe following answer: Because managers do not carefully select which IT activities tooutsource. Thus, we start this chapter by looking at the distinctive IT nature. Wecontinue by discussing sourcing alternatives and global outsourcing. The chapter endswith suggestions regarding strategic IT planning and project management.

Distinctive IT Nature

IT is not just another resource that should be managed like any other resource. Beforeentering outsourcing strategy, there is a need to stand back and carefully consider thespecifics of any IT we put forward as an outsourcing candidate. Lacity and Willcocks(2001) identified the following five characteristics that represent the distinctive natureof IT sourcing decisions:

1. IT is not a homogeneous function, but comprises a wide variety of IT activities.Some IT applications uniquely enable business operations and managementprocesses. Other IT activities, such as accounting systems, may appear lesscritical, but closer scrutiny often reveals that the value of such systems lies in thecross-functional integration of business processes. Outsourcing such activitiescan hinder business performance because suppliers lack an understanding of theimplications IT has on other business processes.



2. IT capabilities continue to evolve at a dizzying pace; thus, predicting IT needspast a 3-year horizon is wrought with uncertainty. Although companies initiallyperceive that suppliers will provide access to new technologies, mega-deals areusually contracted around current technologies with only vague reference tofuture technologies. Most companies find that by the third year into an outsourcingdeal, the original contract actually hinders their adoption of new technologies.

3. There is no simple basis for gauging the economics of IT activity. Although price/performance improvements occur in every industry, in few industries do theunderlying economics shift as fast as IT. A unit of processing power that costs $1million in 1965 costs less than $20,000 today. Today’s computer resources may wellcost 10% less next year. The rapid change in the underlying economics makes itextremely difficult for senior executives to evaluate the long-term costs ofoutsourcing. While a 20% reduction of current IT costs for the next 10 years maybe appealing to a senior executive today, a few years into the contract he or shemay be paying the supplier above-market prices for computer resources. Theeconomics of desktop computing, in particular, change quickly and many managershave been reluctant to lock themselves into a fixed-price outsourcing arrangement.On the other hand, the price of IT skills will continue to be volatile, and in areas ofhigh demand and shortage, escalate, sometimes quite unpredictably. Staying aliveto these switches remains a key skill for client and suppliers alike. Otherwise profitmargins for the supplier can erode quickly; and declining service to the client maybe a consequence.

4. Economic efficiency has more to do with IT practices than inherent economies ofscale. Although there are indeed economies of scale in some aspects of IT, theyoccur at a size achievable by many medium-size and most large-size companies.Therefore, supplier bids are based more on improvements in management practicesthan inherent economies of scale. For example, suppliers may cut costs throughcharge-out mechanisms that motivate business users to manage demand, byconsolidating data centers from multiple sites to one site, or by standardizingsoftware.

5. Most distinctively of all, large switching costs are associated with IT sourcingdecisions. In most areas of business operations, management can protect itselfagainst poor sourcing decisions in a number of ways—by dual sourcing ofcomponent supply or annual contract reviews of an advertising agency. Thesetechniques are often inapplicable or ineffective for IT outsourcing, particularlywhen a total outsourcing approach is taken.

And thus, there is a need to make these characteristics of IT visible as sourcing decisionhas many options. They may not change the decision, but they might play a role indeciding what to outsource, for how long, to whom, and how to build the relationshipwith the vendor.

Enter Strategy 129


Sourcing Alternatives

Companies outsource IT for many reasons, ranging from its high profile and currentpopularity to cost pressures from competition and economic recession. However,industry watchers attribute the growth of the IT outsourcing market to two mainphenomena. First, the interest in IT outsourcing largely results from a shift in businessstrategy. Many companies have abandoned their diversification strategies—oncepursued to mediate risk—to focus on core competencies. As a result, IT has come underscrutiny. Senior executives frequently view the entire IT function as a noncore activityand reason that IT service vendors have the economies of scale and technical expertiseto provide services more efficiently than do internal IT departments. Second, uncertaintyabout IT’s value is another reason for the growth of outsourcing. In many companies,senior executives perceive that IT has failed to deliver the promise of competitiveadvantage propagated in the 1980s and 1990s. Consequently, many senior executivesview IT as a necessary cost to be minimized (Lacity et al., 1996).

Three Sourcing Levels

In situations where a firm does not want to tie up some of its capital resources in IT, itcan hire the IT tasks to be performed by outside companies or vendors. Schniederjans,Hamaker, and Schniederjans (2004) distinguish between the following three outsourcingstrategies:

1. Subcontracting limited work assignments. Short-term, overflow work beyondexisting capacity is assigned to subcontractors or vendors. This is just a temporaryassignment in much the same way as temporary staffers are hired to fill in for summervacation assignment of full-time staffers. This strategy is ideal with security issuesor when cost prohibits more inclusion from a subcontractor.

2. Subcontracting project assignments. Whole IT projects are assigned to subcon-tractors or vendors. These assignments would entail a complete project where themanagement of the project would be delegated to the subcontractor and not underthe control of the IT management of the hiring firm. This strategy is ideal when acompany has unique skill or technology requirements too expensive for them tomaintain but affordable for contractors to offer their clients.

3. Total outsource assignment. Where part (i.e., staff, IT, facilities) or all of the ITfunction is subcontracted out to a subcontractor or vendor. Here a company maylease all its IT from a subcontractor but run the equipment with its own staff. Thisstrategy is ideal when a company may have a market that requires constant changesin IT or cannot afford to tie up capital in IT.

Schniederjans et al. (2004) discuss IT outsourcing from an investment perspective. Theyargue that while IT outsourcing is very popular and can be used to avoid many IT



investment decision-making pitfall situations that traditionally occur, the most commonuse of an outsourcing strategy is where the firm partially outsources and partiallymaintains its own IT resources. This being the case, investment decision makingbecomes even more complicated by outsourcing, as both outsourcing investments andin-house investments have to be evaluated. An IT investment can be defined as adecision of allocating resources to an IT activity. Investment methodologies includebreakeven analysis, payback period, and rate of return, net present value, cost-benefit,and cost-effectiveness. From this perspective, IT outsourcing is to be implemented tothe extent that such investments are profitable.

Four Sourcing Categories

A survey of IT outsourcing experiences in U.S. and U.K. organizations reveal a widespectrum of sourcing decisions, ranging from exclusive use of internal IT functions tolarge-scale IT outsourcing (Lacity & Willcocks, 2000b). This wide spectrum can beclassified into the following four sourcing categories (Lacity et al., 1996):

1. Total outsourcing: the decision to transfer IT assets, leases, staff, and manage-ment responsibility for delivery of IT services from an internal IT function to anexternal IT provider that represents more than 80% of the IT budget.

2. Total insourcing: the decision to retain the management and provision of morethan 80% of the IT budget internally after evaluating the IT services market.Included in the definition of insourcing is the buying-in of vendor resources to meeta temporary need, such as programmers in the latter stages of a new developmentproject or management consultants to facilitate a strategic planning process. Inthese cases, the customer retains responsibility for the delivery of IT services;vendor resources are brought in to supplement internally managed teams.

3. Selective outsourcing: the decision to source selected IT functions from externalprovider(s) while still providing between 20% and 80% of the IT budget internally.This strategy may include single or multiple suppliers. The vendor becomesresponsible for delivering the result of the selectively outsourced IT activities,while the customer remains responsible for delivering the result of the insourcedactivities.

4. De facto insourcing: de facto decision to use internal IT departments to provideproducts and services that arise from historical precedent, rather than from areasoned evaluation of the IT services market.

With these definitions, Lacity et al. (1996) found 14 cases of total outsourcing, 15 casesof total insourcing, and 33 cases of selective outsourcing in their sample of 62 companies.In a later survey, Lacity and Willcocks (2000b) found that 73% of respondents pursuedselective outsourcing, while 22% of organizations exclusively use internal IT functionsto provide IT services, leaving only 5% to total outsourcing.

Enter Strategy 131


Applications service providers (ASPs) deliver and manage applications and computerservices from remote computer centers to multiple users via the Internet or a privatenetwork. Instead of buying and installing software programs, subscribing companies canrent the same functions from these services. Users pay for the use of this software eitheron a subscription or per-transaction basis. The ASP’s solution combines packagesoftware applications and all of the related hardware, system software, network, andother infrastructure services that the customer otherwise would have to purchase,integrate, or manage independently. The ASP customer interacts with a single entityinstead of an array of technologies and service vendors. Companies are turning to thissoftware service model as an alternative to developing their own software. Somecompanies will find it much easier to rent software from another firm and avoid the expenseand difficulty of installing, operating, and maintaining the hardware and software forcomplex systems, such as enterprise resource planning (ERP) systems. The ASPcontracts guarantee a level of service and support to ensure that the software is availableand working at all times. Today’s Internet-driven business environment is changing sorapidly that getting a system up and running in three months instead of 6 could mean thedifference between success and failure. ASPs also enable small and medium-sizecompanies to use applications that they otherwise could not afford (Laudon & Laudon,2005).Barthélemy and Geyer (2004) study determinants of total IT outsourcing in French andGerman firms. The total versus selective IT outsourcing dichotomy is a classic in theliterature, and they report the following findings from their study:

• For firms that outsource IT, the likelihood of total outsourcing is higher when thecost reduction motivation is strong.

• For firms that outsource IT, the likelihood of total outsourcing is lower when theIT department is large.

• For firms that outsource IT, the likelihood of total outsourcing is lower in IT-intensive sectors.

• For firms that outsource IT, the likelihood of total outsourcing is higher for Frenchfirms than for German firms.

They found no support for the hypothesis that performance improvement motivation isa significant factor or the hypothesis that non-IT senior executives’ involvement is asignificant factor.

Analysis Framework

A typical analytical framework to aid in decisions concerning outsourcing, developedby Earl (1996), is offered in Figure 5.1. The guiding parameters are the business value ofa technology or application and the operational performance of the associated service.The framework suggests, for example, that outsourcing of IS central to business strategymay be a dangerous diversion, especially if IT operations are already efficient. Insourcing



in this situation is preferred. If business value is high but operational performance isweak, then market testing (or benchmarking) might make sense, at least so a company cansee what performance improvement might be possible by either internal or externalsourcing. However, if operational performance is weak and the business value of theparticular technology or application is low, then outsourcing is a more obvious route toimprovement. Finally, smart sourcing or selective outsourcing might be a way to simplifythe IT domain when elements of it are satisfactory for operational performance but notcentral to business capability or strategy.Such arguments are intuitively appealing at an analytical and general level. The troubleis that they can be simplistic in practice. They do not account for the complexities thatpermeate the management of information resources. Managers should always askthemselves why does outsourcing make sense and why does it not make sense to thecompany in the current situation.

Selective Outsourcing

Lacity et al. (1996) argue that the debate about all-or-nothing outsourcing has obscuredthe real issue. The question is not, “Should we outsource or insource IT?” but rather,“Where and how can we take advantage of the developing market for IT services?” Itseems that successful companies carefully select which IT activities to outsource,rigorously evaluate vendors, tailor the terms of the contract, and carefully manage thevendor. IT activities for outsourcing consideration can be classified into differentcategories. Grover et al. (1996) defined five categories labeled applications developmentand maintenance, systems operations, telecommunications management and mainte-nance, end-user support, and systems planning and management:

1. Applications development and maintenance includes systems analysis, design,and construction of application software and the accompanying software mainte-nance.

Figure 5.1. IT sourcing strategies

Market testing Insource Benchmarking (Re)integration Outsource Smart source Vendor all Vendor some

Core

Business value of IT

Commodity

Anxieties Satisfaction Operational performance of IT

Enter Strategy 133


2. Systems operations include mainframe and minicomputer operations for dailyprocessing runs, backup and recovery, and systems software maintenance.

3. Telecommunications management and maintenance includes hardware and soft-ware development for telecommunications, daily management of voice, video, data,and/or image communications, and network operations and maintenance.

4. End-user support includes PC procurement, user education and training, and userconsulting.

5. Systems planning and management includes highly asset-specific activities suchas project management, personnel management, financial management, and admin-istrative support.

What should be outsourced successfully? Grover et al. (1996) studied outsourcingsuccess. Outsourcing success was defined as high score on the following items:

• We have been able to refocus on core business.• We have enhanced our IT competence.• We have increased access to skilled personnel.• We have enhanced economies of scale in human resources.• We have enhanced economies of scale in technological resources.• We have increased control of IS expenses.• We have reduced the risk of technological obsolescence.• We have increased access to key information technologies.• We are satisfied with our overall benefits from outsourcing.

Given these items to measure outsourcing success, the researchers looked for relation-ships between outsourcing categories and outsourcing success. The outsourcing ofsystems operations and telecommunications management and maintenance showed asignificant relationship with outsourcing success. The outsourcing of applicationsdevelopment and maintenance, end-user support, and systems planning and manage-ment did not show a significant relationship with outsourcing success. We have toremind ourselves that this research was conducted a decade ago. Nevertheless, bothcategorization and empirical results are interesting to note. A statistical test of overalloutsourcing reflecting an average effect of the results of all five categories was alsoconducted. Overall outsourcing showed a positive relationship with success. Thisindicates that, on average, outsourcing does realize benefits for the service receiver.We find other categorizations in different research literature. For example, Ang andStraub (1998) define eight categories labeled IS strategy, IT planning, capacity manage-ment, production scheduling, human resources management, security management,network management, and personal computer (PC) management. They found thatgreatest extent of outsourcing in capacity management, and the least extent in PCmanagement.



Insourcing

Hirschheim and Lacity (2000) argue that the current IT sourcing research covers themotivations and consequences of outsourcing, and has neglected another importantoption—insourcing. They define insourcing as the practice of evaluating the outsourcingoption, but confirming the continued use of internal IT resources to achieve the sameobjectives of outsourcing. They believe that insourcing must be fully explored tocomplement the growing body of outsourcing research. Only by understanding theprocesses and outcomes of both outsourcing and insourcing can a comprehensiveunderstanding of IT sourcing result. This unexplored insourcing option provided themotivation behind Hirschheim and Lacity’s research. Can internal IT departmentsachieve the same results as outsourcing vendors? If so, why have they not done so inthe past? Do IT departments actually reduce costs or improve service after winning aninsourcing bid? If so, how did IT departments achieve the results? They conducted 14insourcing case studies to research these issues.The issues associated with the choice of an IT sourcing strategy are often murky, hiddenbehind euphemisms, perceived differently by different stakeholder groups, and gener-ally not easily analyzed. Nevertheless, in trying to explain what they found in theirresearch about these issues, Hirschheim and Lacity (2000) noted certain similarities anddifferences in patterns and these coalesced around four loosely connected alternativesin the way organizations approach IT insourcing. These four alternative approaches aredescribed in terms of archetypes:

• Archetype 1: Senior executives enable internal IT managers to cut costs. It beginswhen external pressures threaten the organization causing senior management tosearch for ways to reduce costs, including IT costs. Under this scrutiny, seniorexecutives question the value of rising IT expenditures and mandate that ITmanagers cut costs. IT managers counter that costs are high because users resisttheir cost reduction tactics. Senior management despairs at the gridlock andformally invites outsourcing vendors to submit bids. IT managers rally, requestingthey be allowed to compete with vendor bids.

• Archetype 2: IT managers terminate failing outsourcing contracts. Due to poorlynegotiated contracts, IT costs rose and service levels dropped. The senior ITmanagers assemble a case to terminate the outsourcing contract and rebuilt theinternal IT organization. Senior executives and users support the IT managers’proposals. After an initial investment, IT costs drop and service levels improve asa result of insourcing.

• Archetype 3: IT managers defend insourcing. This archetype is the first time inwhich insourcing results in a financial failure in that no cost savings occur. ITmanagers take charge of the outsourcing evaluation for a number of politicalreasons, such as proving efficiency, justifying new resources, or trying to enhancetheir reputation as business persons. They used the outsourcing evaluations toconfirm to senior management the legitimacy of continued sourcing through theinternal IT departments.

Enter Strategy 135


• Archetype 4: Senior executives confirm the value of IT. This archetype indicatesthe case where the insourcing decisions did not result in significant reduction inIT costs, but the insourcing decisions were still considered a success becausecompanies revalidated and further legitimated internal sourcing. In these compa-nies, organizational structures and processes are implemented to demonstrate thecost effectiveness of their IT departments.

Hirschheim and Lacity (2000) contend that outsourcing evaluations often result from thefrustrations caused by different stakeholder expectations and perceptions of IT perfor-mance. This belief is based on an analysis of what IT managers can realistically achieveversus what senior executives and users expect them to achieve. Different stakeholderperspectives set unrealistic performance expectations for IT managers, leading tofrustration, loss of faith in internal IT management, and hopes that outsourcing vendorswill provide the solutions.

Outsourcing Preparations

The growth of the number and size of outsourcing deals has been paralleled by risingconcern with how these deals can be managed, and in particular how the risks theyrepresent can be controlled. Risk here is taken to be a negative outcome that has a knownor estimated probability of occurrence based on experience or some theory. Risk is thelikelihood of loss as a consequence of uncertainty. Risk has emerged as a key issue inIT outsourcing, not least because of the very mixed picture on success emerging fromthe trade press and the academic evidence. According to Lacity and Willcocks (2001),the main reasons for failure or negative outcomes in IT outsourcing deals have beenvarious combinations of the following 10 factors:

1. Treating IT as an undifferentiated commodity to be outsourced2. Incomplete contracting3. Lack of active management of the supplier on contract and relationship dimensions4. Failure to build and retain requisite in-house capabilities and skills5. Power asymmetries developing in favor of the vendor6. Difficulties in constructing and adapting deals in the face of rapid business and

technical change7. Lack of maturity and experience of contracting for and managing total outsourcing

arrangements8. Outsourcing for short-term financial restructuring or cash injection rather than to

levering IT assets for business advantage9. Unrealistic expectations with multiple objectives for outsourcing10. Poor sourcing and contracting for development and new technologies



For risk mitigation, all these 10 risk factors have to be managed. Otherwise, theorganization is likely to fail when handing over IT without understanding its role in theorganization, and what the vendor’s capabilities are. One rule of thumb is: Neveroutsource a problem; only an IT activity or set of tasks that a detailed contract andperformance measures can be written for.In addition to risk mitigation, there is another important preparation for outsourcingconcerning core IT capabilities. A focus on key capabilities and skills reflects a resource-based approach to how organizations can survive, pursue stakeholder objectives, andcompete. Lacity and Willcocks (2001) identified nine emerging key capabilities requiredfor any future high-performance IT function: governance, business systems thinking,relationship building, architecture planning, making technology work, informed buying,contract facilitation, contract monitoring, and supplier development. For IT capabilitiesmanagement, all these nine key capabilities have to be identified. Otherwise, theorganization is likely to fall behind other high-performance IT functions.

Global Outsourcing

Global outsourcing is a fast-growing aspect of the world economy. It has been estimatedthat 3.3 million jobs worldwide will move offshore. Clott (2004) has studied perspectiveson global outsourcing and the changing nature of work. The strategic benefits for firmscan be portrayed as a means to reduce costs, improve asset efficiency, and increaseprofits. Criticisms of outsourcing have often been in the areas of changing employmentpatterns, globalization of labor force, and its effects on individuals and organizations.Outsourcing has been called one of the greatest organizational and industry structureshifts of the century, with the potential to transform the way businesses operate. Someproponents believe it will turn firms from vertically integrated structures into virtualorganizations and transform existing fixed structures into variable-cost structures whereexpenses can move up or down as the business climate dictates. For employees, the trendtoward outsourcing has been thought to result in a loss of fixed-employment opportu-nities as a consequence of firms seeking to use cheaper labor overseas.Underpinning the move toward outsourcing has been a confluence of structural andtheoretical changes in the nature of business and organizations dating back approxi-mately two decades. Theorists have suggested that the changing nature of competitionhas resulted from two factors: (1) globalization of commerce engendering worldwidecompetition and (2) technology developments that have changed basic businessprocesses related to time and distance. Globalization and technology have placedenormous pressure on firms to cut costs and improve efficiency in the interests of self-preservation (Clott, 2004).The industry most closely associated with outsourcing has been IT. IT functions havebeen outsourced to such an extent that the “New Silicon Valley” centered in and aroundthe city of Bangalore, India, which became a major outsourcing provider for IT functionsas a result of its lower costs and advanced processing skills. This led to the growth oflarge Indian outsourcing firms such as Infosys, Tata Consultancy, and Wipro. As of 2003,

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over 500,000 people were employed in the Indian IT industry. Other countries seekingto replicate India’s growth as an IT center for U.S. firms are Ireland, Israel, and thePhilippines. As of 2004, among the fastest-growing aspects of global outsourcing isbusiness process outsourcing (BPO). BPO began as back-office process arrangementsto run finance and accounting operations such as payroll, accounts payable andreceivable, financial, insurance, and property accounting. These services have expandedinto new areas such as call centers, with staff trained to answer and transact basic service-related areas, including order entry and credit card processing (Clott, 2004).Wage rate differentials generate cost savings, but the really compelling gains come frompairing savings with top-flight skills. While only a few Asian countries offer enoughEnglish-speaking call-center representatives and help-desk functions to deal withforeign customers, many other skills are more abundant in Asia than in Europe and theUnited States. According to Hagel (2004), China, for example, produces 350,000 graduateengineers every year, compared to 90,000 for U.S. engineering schools. And most leadingIndian IT-outsourcing firms operate at level five—the highest degree of expertise—ofthe IT service capability maturity model, whereas most internal IT departments in theUnited States operate at levels two or three. Many skills of Asian companies aredistinctive. Product engineers in China and Taiwan, for instance, are more focused ondesigning for production than are their U.S. counterparts, who tend to emphasizefeatures and product performance. The combination of low wages and a plentiful supplyof skilled applicants makes it possible for Asian companies to use managerial practicesvery different from those generally found in developed economies. To begin with, thebest offshore companies invest heavily to recruit the right staff because they can affordto be more selective. Furthermore, there are more managers to staff, so that they can spendmore time building the skills of employees.According to Wright and Boschee (2004), workers and managers in the technology fieldalmost certainly have heard of companies such as Infosys, Wipro, Cordiant, Tata,MachroTech, and others. These companies are among many technology shops basedin India that have taken over a growing share of technical work outsourced by U.S. andother firms, which use Indian IT providers for software engineering, applicationsdevelopment, customer service call centers, and many other high-tech needs. Thesuccess of these offshore providers of outsourced IT derives in large part from twoeconomic trends. First, in the wake of the recession, U.S. businesses have focusedincreasingly on their core skills and outsourced a broad variety of services not integralto their mission, with technology services leading the way. Second, with revenues flator shrinking, businesses have focused on cutting costs, again with an eye on the highprice of technology. The formula of Indian IT companies to capitalize on those trends issimple: excellent technology service at much lower cost. Much of their reduced coststructure is based on their use of highly skilled Indian technology professionals, whoare often paid substantially less in India than technology workers in the United States.With the U.S. employment marked in a slump—and the once high-flying technologysector leaving a large trail of laid-off American technical workers—politicians and U.S.workers alike have begun complaining bitterly about the flow of outsourced work tooffshore providers.Such complaints can have consequences for international outsourcing when labormarkets are unionized. Skaksen (2004) found that international outsourcing may give rise



to an increase in the wage rate, which implies that remaining home-country workers maybecome economically better off, even though jobs are moved out of the country.Potential, or the threat of, global outsourcing also has important implications for the wagerate and the level of employment. Potential but nonrealized international outsourcing canbe used as a threat by the firm in the wage negotiations with the trade union. Under thesecircumstances, a marginal decrease in the cost of international outsourcing implies thatthere is a decrease in the wage rate and an increase in employment and aggregate socialwelfare. With respect to the implications of realized global outsourcing, Skaksen (2004)found that a marginal decrease in the cost of such outsourcing, which implies that thefirm actually begins to outsource activities, gives rise to an increase in the wage rate anda reduction in employment and aggregate social welfare.According to Venkatraman (2004), the new hot topic being debated in boardrooms, atmeetings, and in Internet discussion groups is offshoring, the practice especially amongU.S. and European companies of migrating business processes overseas to India, thePhilippines, Ireland, China, and elsewhere to lower costs without significantly sacrificingquality. At first blush, this would seem like nothing new, but the development of apowerful communication infrastructure is making offshoring an increasingly viable andcommonly taken option. Nearly two out of three software companies are alreadyinvolved, and in a number of industries, IT-enabled back-office business processes areprime candidates for such a shift. The debate about the ethics of offshoring misses thepoint that it represents the inevitable next generation of business practice. At the heartof the debate is the issue of jobs and wages. As networking technologies have enabledcompanies to tap into the global marketplace for talent more easily, offshoring has putdownward pressure on domestic salaries.The shifting geography of business processes can be defined as the third wave ofgeography-related change in the design and operation of corporations. During the firstwave, the improving transportation infrastructure of the 20th century enabled corpora-tions to seek effective production capabilities in increasingly far-flung locations thatprovided access to new markets and tangible resources—land, local factories, mines, andproduction workers. During the second wave, as capital markets became global andinterconnected in the latter half of the 20th century, corporations began to capitalize onvibrant global financial markets for both debt and equity. Now we are in the midst of athird wave in which digitized business processes such as order processing, billing,customer service, accounts and payroll processing, and design and development can becarried out without regard to physical location (Venkatraman, 2004).Business Week (2004) asked, “Will outsourcing hurt America’s supremacy?” Fordecades, the United States has been the world’s technology leader thanks in large partto its dominance of software. The question now is whether the United States can continueto lead the industry as programming spreads around the globe from India to Bulgaria.Optimists see the offshore wave as the latest productivity miracle of the Internet.Companies that manage it well—no easy task—can build virtual workforces spreadaround the world, not only soaking up low-cost talent, but also tapping the biggest brainson earth to collaborate on complex projects. One major challenge, then, is to organize thework in such a way that knowledge can be exchanged between traditional separation linesand across borders. The line of separation is not only between managers and employees,but also between government and private companies, single companies and industry

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networks, and between research and development units and operational units. Globaloutsourcing might have major implications on future knowledge-based product andservice production.Kaiser and Hawk (2004) argue that there is currently an evolution of offshore softwaredevelopment from outsourcing to cosourcing. “Financial Insurance Services Company”(FISC) (a pseudonym) is a major U.S. financial services company with thousands ofrepresentatives across the country. “Offsource” (a pseudonym) is a leading India-basedcompany providing consulting and IT services to clients globally. Kaiser and Hawk tellhow their 8-year alliance has evolved. The relationship began as a simple pilot of offshoreapplication development outsourcing aimed at reducing development costs and supple-menting in-house IT staff knowledge. It has evolved into a vastly more complex“cosourcing” model, where work is shared. To achieve cosourcing, the two firms had toresolve two major issues. The first was how to keep IT skills and knowledge from drainingfrom FISC. This issue has been resolved by formally linking career development to projectassignments and to outsourcer-to-client mentoring. The second issue is how to sharework. It has been resolved by creating a dual project management hierarchy, whereleadership at each level of a project can be either by FISC or Offsource, depending onthe need. Their experiences provide five recommendations for others on structuringoffshore outsourcing relationships: (1) understand where cosourcing is applicable, (2)define and develop the appropriate in-house IT competencies, (3) build trust but avoidbuilding a binding relationship, (4) foster mutual understanding of ethnic and corporatecultures, and (5) map out a progression to cosourcing.Public administration is changing, and new publication management strategies includethe globalization of public services production. Inside government agencies bureau-shaping motivations sustain the new public management model approach and create astrong disposition toward embracing radical outsourcing, and residualizing government’simplementation roles, a direction reinforced by the marketization of public services.Transnational pressures on nation states to standardize policies will powerfully erodethe existing single-country distinctiveness of public service markets. Globalization ofpublic services production is likely for two main reasons (Dunleavy, 1994):

• Market pressures for globalization. There are five principal market pressures forglobalization of private services production, all of which are likely to haveimportant corollaries or implications for public services production: the contempo-rary growth of services, changes in technology, new forms of commercial andindustrial organization by firms, the development of radical outsourcing, andchanges in commodification processes. Radical outsourcing strategies have hadfar-reaching effects on service growth and the reorganization of corporations bysplitting up previously unitary organizational configurations.

• State pressures for globalization. Within the public sector, there are analogouspressures for globalization, and some key differentiating features. There are fourprincipal state pressures: the bureau-shaping incentives acting on bureaucrats andpublic officials, the potential for radical outsourcing in the public sector, theimpacts of government procurement rules, and consequent changes affecting thecommodification of public services. Radical outsourcing in the public sector entails



generalizing best in the world criteria from firms’ and corporations’ activity to applyalso to public service operations.

However, Dunleavy (1994) argues that governments will find it extraordinarily hard tomeet the best-in-the-world criterion applied to many or most of their service activities.As large corporations progressively develop and refine their capabilities in current ornew implementation areas, they will often be able to acquire extra focus in depth, to makelarge capital investments, and to reap economies of scale by producing standardizedservice packages across many different localities, regions, or countries. Unlike mostgovernmental units, corporations are able to rapidly change their scope of operations bymerging, setting up partnership deals, or franchising, so that scale escalation in thecorporate economy can rather quickly affect public services production. Major corpo-rations are already emerging in key public service areas, and they will be able to takeseriously best-in-the-world criteria. From this perspective the prospect of trans-Euro-pean or transglobal firms becoming major players in defining and developing publicservices production is likely.The bureau-shaping model also sheds light on the scope for radical outsourcing insidegovernment. Bureau-shaping incentives have emerged as dominant bureaucratic re-sponses to the end of the postwar growth era in public services employment. Rationallyself-interested bureaucrats have little stake in maximizing budgets and expandingempires, as older public choice models suggested. The biggest potential for radicaloutsourcing lies in a large-scale shift to contracting of delivery agencies, where publicofficials directly organize implementation of public services (Dunleavy, 1994).

Strategic IT Planning

IT outsourcing strategy should be embedded in IS/IT strategy. Developing an IS/ITstrategy is taken to mean thinking strategically and planning for the effective long-termapplication and optimal impact of electronic information to support and influencebusiness performance in the organization. Strategy can simply be defined as principles,a broad-based formula, to be applied in order to achieve a purpose. These principles aregeneral guidelines guiding the daily work to reach business goals. Strategy is the patternof resource development and application decisions made throughout the organization.These encapsulate both desired goals and beliefs about what are acceptable and, mostcritically, unacceptable means for achieving them.Resource-based strategy is concerned with development and application of resources.While the business strategy is the broadest pattern of resource decisions, more specificdecisions are related to IS and IT. IS must be seen both in a business and an IT context.IS is in the middle because IS supports the business while using IT. As part of a resource-based strategy, both IS and IT represent capabilities and resources that have bedeveloped.Business strategy is concerned with achieving the mission, vision, and objectives of acompany, while IS strategy is concerned with use of IS/IT applications, and IT strategy

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is concerned with the technical infrastructure as illustrated in Figure 5.2. A company hastypically several IS/IT applications. The connection between them is also of greatinterest, as interdependencies should prevent applications from being separate islands.Furthermore, the arrows in Figure 5.2 are of importance. Arrows from business strategyto IS strategy, and from IS to IT strategy represent the alignment perspective, theyillustrate what before how. Arrows from IT to IS strategy, and from IS to businessstrategy represent the extension from what to how to what. This is the impact perspective,representing the potential impacts of modern information technology on future businessoptions.Necessary elements of a business strategy include mission, vision, objectives, marketstrategy, knowledge strategy, and our general approach to the use of information, IS, andIT.Mission describes the reason for firm existence. For example, the reason for a law firmexistence is clients’ needs for legal advice. The mission addresses the organization’sbasic question of “What business are we in?” This single, essential, sentence shouldinclude no quantification, but must unambiguously state the purpose of the organizationand should just as carefully define what the organization does not do. According to Wardand Peppard (2002, p. 189), the mission is an unambiguous statement of what theorganization does and its long-term, overall purpose:Its primary role is to set a direction for everyone to follow. It may be short, succinct andinspirational, or contain broad philosophical statements that tie an organization tocertain activities and to economic, social, ethical or political ends. Values are alsofrequently stated alongside the mission. Three widely differing examples of missions are:

a. To be the world’s mobile communications leader, enriching the lives of individualsand business customers in the networked society (large global telecommunicationcompany)

Figure 5.2. Relationships between strategies at three levels

THE BUSINESS Mission, vision and objectives,

market strategy, knowledge strategy, use of information

Business strategy

IS Applications and

interdependencies between systems

IS strategy

IT Technical platform

for IS

IT strategy



b. To eradicate all communicable diseases worldwide (World Health Organization)c. The company engages in the retail marketing on a national basis of petroleum

products and the equitable distribution of the fruits of continuously increasingproductivity of management, capital and labor amongst stock holders, employeesand the public (a large public company)

Vision describes what the firm wants to achieve. For example, the law firm wants tobecome the leading law firm in Norway. The vision represents the view that seniormanagers have for the future of the organization; so it is what they want it to become.This view gives a way to judge the appropriateness of all potential activities that theorganization might engage in. According to Ward and Peppard (2002), the vision givesa picture, frequently covering many aspects, that everyone can identify with, of what thebusiness will be in the future, and how it will operate. It exists to bring objectives to life,and to give the whole organization a destination that it can visualize, so that everystakeholder has a shared picture of the future aim.Objectives describe where the business is heading. For example, the law firm can chooseto merge with another law firm to become the leading law firm in Norway. Objectives arethe set of major achievements that will accomplish the vision. These are usually small innumber, but embody the most important aspects of the vision, such as financial returns,customer service, manufacturing excellence, staff morale, and social and environmentalobligations.Market strategy describes market segments and products. For example, the law firm canfocus on corporate clients in the area of tax law.The most important business strategy part may be concerned with knowledge strategy.According to Zack (1999, p. 135), a knowledge strategy describes the overall approachan organization intends to take to align its knowledge resources and capabilities to theintellectual requirements of its strategy:A knowledge strategy describes the overall approach an organization intends to take toalign its knowledge resources and capabilities to the intellectual requirements of itsstrategy. It can be described along two dimensions reflecting its degree of aggressive-ness. The first addresses the degree to which an organization needs to increase itsknowledge in a particular area vs. the opportunity it may have to leverage existing butunderutilized knowledge resources—that is, the extent to which the firm is primarily acreator vs. user of knowledge. The second dimension addresses whether the primarysources of knowledge are internal or external. Together these characteristics help a firmto describe and evaluate its current and desired knowledge strategy.The business strategy part concerned with use of information and IT is sometimes calledan information management strategy. The general approach to the use of information, ISneeds and IT investments are described in this part. For example, the ambition level forIT in knowledge management is described, and the general approach to selection ofambition level and combination of ambition levels I–IV are discussed.Necessary elements of an IS strategy include future IS/IT applications, future compe-tence of human resources (IS/IT professionals), and future IS/IT organizational struc-ture, and control of the IS/IT function. An important application area is knowledge

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management systems (KMS). The future applications are planned according to priorities,how they are to be developed or acquired (make or buy), how they meet user requirements,and how security is achieved. The future competence is planned by types of resourcesneeded, motivation and skills needed (managers, users, IS/IT professionals), salaries,and other benefits. The future IS/IT organization defines tasks, roles, management, andpossibly outsourcing.Necessary elements of an IT strategy include selection of IT hardware, basic software,and networks, as well as how these components should interact as a technologicalplatform, and how required security level is maintained. The IT platform consists ofhardware, systems software, networks and communications, standards, and supportfrom selected vendors.An IS/IT strategy is a combined strategy including business context, the IS in a narrowsense and the technological platform. Necessary elements of an IS/IT strategy includebusiness direction and strategy (mission, vision, objectives, knowledge strategy),applications (knowledge management systems), people (future competence of humanresources), organization (future organization and control of IT function), and IT platform(future technical infrastructure). Hence, IS/IT strategy is quite a broad term. The term isbroad to take care of all connections and interdependencies in a strategy, as changes inone element will have effect on all other elements, as illustrated in Figure 5.3.Why is strategic IS/IT planning undertaken within business organizations? Hann andWeber (1996) see IS/IT planning as a set of activities directed toward achieving thefollowing objectives:

1. Recognizing organizational opportunities and problems where IS/IT might beapplied successfully

2. Identifying the resources needed to allow IS/IT to be applied successfully to theseopportunities and problems

3. Developing strategies and procedures to allow IS/IT to be applied successfully tothese opportunities and problems

4. Establishing a basis for monitoring and bonding IT managers so that their actionsare more likely to be congruent with the goals of their superiors

Figure 5.3. IS/IT strategy elements and interdependencies

STRATEGIC DIRECTION Business direction and knowledge strategy, knowledge management strategy and

ambition level for IT in knowledge management

SYSTEMS Applications such as knowledge

management systems (KMS)

TECHNOLOGY IT platform including hardware, software and communication

SUPPORT Organization of knowledge

management and IT support

COMPETENCE People such as managers,

knowledge workers, and IT support



5. Resolving how the gains and losses from unforeseen circumstances will bedistributed among senior management and the IT manager

6. Determining the level of decision rights to be delegated to the IT manager

In the following, we present a model for development of an IS/IT strategy for knowledgemanagement. However, we do not limit strategy work to knowledge management. Rather,we describe the complete IS/IT strategy work where knowledge management is a naturalpart of it. This is done to keep a complete strategy work process. A limited strategy onlyfor knowledge management can cause suboptimal solutions for the company.Empirical studies of IS/IT planning practices in organizations indicate that wide varia-tions exist. Hann and Weber (1996) found that organizations differ in terms of how muchIS/IT planning they do, the planning methodologies they use, the personnel involvedin planning, the strength of the linkage between IS/IT plans and corporate plans, thefocus of IS/IT plans (e.g., strategic systems vs. resource needs), and the way in whichIS/IT plans are implemented.It has been argued that the Internet renders strategic planning obsolete. In reality, it ismore important than ever for companies to do strategic planning (Porter, 2001):

Many have argued that the Internet renders strategy obsolete. In reality, the oppositeis true. Because the Internet tends to weaken industry profitability without providingproprietary operational advantages, it is more important than ever for companies todistinguish themselves through strategy. The winners will be those that view theInternet as a complement to, not a cannibal of, traditional ways of competing.

In the following, the Y model for strategy work is discussed and applied. The modelprovides a coherent step-by-step procedure for development of an IS/IT strategy. In allkinds of strategy work, there are three steps. The first step is concerned with analysis.The second step is concerned with choice (selection and decision), while the final stepis concerned with implementation. We now introduce a model for strategy work. This isillustrated in Figure 5.4. The model consists of seven stages covering analysis, choice,and implementation. The stages are as follows:

1. Describe current situation. The current IS/IT situation in the business can bedescribed using several methods. The benefits method identifies benefits from useof IS/IT in the business. Distinctions are made between rationalization benefits,control benefits, organizational benefits, and market benefits. Other methodsinclude the three-era model, management activities, and stages of growth.

2. Describe desired situation. The desired business situation can be described usingseveral methods described in the first chapter: value configurations, competitivestrategy, management strategy, business process redesign, knowledge manage-ment, the Internet and electronic business, and IT benefits.

3. Analyze and prioritize needs for change. After descriptions of the currentsituation and the desired situation, needs for change can be identified. The gap

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Figure 5.4. The Y model for IS/IT strategy work

between desired and current situation is called needs for change. Analysis is toprovide details on needs, what change is needed, and how changes can take place.What analysis will create an understanding of vision and goals, knowledgestrategy, market strategy, and corporate problems and opportunities. How analysiswill create an understanding of technology trends and applications. These analy-ses should result in proposals for new IS/IT in the organization.

4. Seek for alternative actions. When needs for change have been identified andproposals for filling gaps have been developed, alternative actions for improvingthe current situation can be developed. New IS/IT can be developed, acquired, andimplemented in alternative ways. For example, an IS can be developed in-house by

Current situation

Need for change

Desired situation

Alternative actions

Action

Results

Evaluation

1. Describe the current situation 2. Describe the desired situation

3. Analyze needs for change

4. Seek for alternative actions

5. Select actions and make an action plan

7. Evaluate results

6. Implement plan and describe results



company staff, it can be purchased as a standard application from a vendor, or itcan be leased from an application systems provider (ASP).

5. Select actions and make an action plan. When needs for change and alternativeactions have been identified, several choices have to be made and documented inan action plan. Important issues here include development process, user involve-ment, time frame and financial budget for IS/IT projects.

6. Implement plan and describe results. This is the stage of action. Technicalequipment such as servers, PCs, printers, and cables are installed. Operatingsystems are installed. Application packages, software programs, programmingtools, end-user tools, and database systems are installed. Development projectsare organized. Management and user training takes place. Document results overtime.

7. Evaluate results. Implementation results are compared with needs for change. Itis determined to what extent gaps between desired and current situation have beenclosed. This is the beginning of the IS/IT strategy revision process, where a newprocess through the Y model takes place. Typically, a new IS/IT strategy processwill take place every other year in business organizations.

While stages 1 to 3 cover analysis, 4 and 5 cover choice, and 6 and 7 cover implemen-tation. In some strategy models, stage 2 is listed as the first stage. It is here recommendedto do stage 1 before stage 2. It is easier to describe the ideal situation when you knowthe current situation. If you start out with stage 2, it often feels difficult and abstract todescribe what you would like to achieve. Having done stage 1 first makes the work morerelevant. Stage 3 is a so-called gap analysis, looking at the difference between the desiredand actual situation. This stage also includes prioritizing. Stage 4 is a creative sessionas it calls for ideas and proposals for alternative actions. Stages 5 and 6 are typicalplanning stages. The final stage 7 is important because we can learn from performing anevaluation.An IT outsourcing strategy should be embedded in IS/IT strategy. IT outsourcingdecision making occurs at several of the stages in the Y model. However, the mostimportant stages where IT outsourcing decisions can be made are stage 4 of seekingalternative actions and stage 5 of selecting action.Successful strategic IT planning will often imply transformational outsourcing asdiscussed in Chapter II. The result of IS/IT strategy may be a complete transformationof the IT function, where IT outsourcing is only one of many important parts of thetransformation. Other parts of the transformation may be for example from systemsprovider to infrastructure planner, from business standards to industry standards, fromsystems analysts to business consultants, and from craftsmen to project managers.Transformational outsourcing is concerned with bringing new capabilities to the orga-nization through important sets of skills that will be identified in strategic IT planning.

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Project Management

Outsourcing is often organized as a project. The project is concerned with turning overall or parts of an IT activity to an outside vendor. The user organization (client) transfersproperty decision rights over IT infrastructure to an external (vendor) organization. Theproject is a process whereby an organization decides to contract-out or sell the firm’s ITassets, people and/or activities to a third-party supplier, who in exchange provides andmanages these assets and services, for an agreed fee over an agreed time period.IT functions and tasks are typically organized as projects. IT management has largelybeen a project-driven exercise. Whether the goal is to design, install, or reengineer,technology initiatives are often driven by aggressive deadlines and periods of frequentchange. To get the job done, resources must be identified and allocated, and activitiesmust be properly organized and structured in accordance with business and technicalrequirements.IT projects come in many shapes and sizes, for example, feasibility studies, developmentprojects, design projects, implementation projects, upgrade projects, migration projects,support services projects, and outsourcing projects. The project management approachto solving IT problems and employing opportunities involves a number of stakeholders,such as managers and end users. It defines activities, plans and milestones, andresponsibilities. In IT projects the project managers are important players in making themost of the potentials of IT. The need for improved performance in IT projects has beenemphasized in both empirical and prescriptive research studies (Gottschalk & Karlsen,2002). For example, substantial hidden costs are often associated with IT outsourcingprojects. Hidden costs from outsourcing vendor search and contracting costs are costsof gathering information to identify and assess suitable vendors and costs of negotiatingand writing the outsourcing contract (Barthélemy, 2003b).Cost, time, and quality have over the last decades become inextricably linked withmeasuring the success of project management. It has been suggested that the benefitsfor the client organization and stakeholders are just as important performance measuresfor IT as the time-cost-quality criteria.Leadership is an important determinant of performance in IT projects. Today’s complexproject setting requires greater skills in leadership and management than ever before. Inthe highly competitive arena in which most IT projects operate, the requirement toproduce results that exceed the base organization’s expectations has become the norm.Within project management, the concept of leadership has been studied extensively.Thite (2000) investigated leadership styles in information technology projects, and hemade a distinction between technical leadership and transformational leadership. Asopposed to Thite and other literature about project leadership, we will apply the conceptof management roles to outsourcing projects. Leadership style can be defined as a focusof attention, while management role can be defined as a focus on behavior (Karlsen &Gottschalk, 2002).Managers undertake activities to achieve the objectives of the organization. A numberof different and sometimes conflicting views of manager’s role can be noted. Often, oneparticular aspect of the manager’s job is emphasized to the exclusion of others. In sum,



they perhaps cover all the aspects. A role typology is frequently used in studies ofmanagerial work and is genderless. In the context of IT management, the relevance of sixproject management roles can be identified—leader, resource allocator, spokesperson,entrepreneur, liaison, and monitor. The following role descriptions can be used:

• Leader. As the leader, the project manager is responsible for supervising, hiring,training, organizing, coordinating, and motivating a cadre of project personneltoward the project goal. Literature has emphasized the impact of this role on projectpersonnel. This role is mainly internal to the project.

• Resource allocator. The project manager must decide how to allocate human,financial, and information resources to the project. This role emphasizes planning,organizing, coordinating, and controlling project tasks and is mainly internal to theproject.

• Spokesperson. As a spokesperson the project manager extends his/her contactsoutside the project to other areas of the organization. This role emphasizesacceptance of the project within the organization. Frequently, she or he must crosstraditional departmental boundaries and become involved in matters of production,distribution, marketing, and finance.

• Entrepreneur. The project manager identifies users’ needs and managementexpectations and develops solutions that change business situations. A majorresponsibility of the project manager is to ensure that rapidly evolving technicalopportunities are understood, planned, implemented, and strategically exploited inthe organization.

• Liaison. In this role, the project manager communicates with the external environ-ment. This communication includes exchanging information with externaloutsourcing stakeholders and vendors. This is an active, external role.

• Monitor. This role emphasizes scanning of the external environment to keep upwith relevant technical changes and competition. The project manager identifiesnew ideas from resources outside the organization. For example, other companies’outsourcing experiences and plans are scanned. To accomplish this, the projectmanager uses many resources including vendor contacts, professional relation-ships, and a network of personal contacts.

The six roles are illustrated in Figure 5.5. Leader and resource allocator are roles internalto the IT project. Spokesperson and entrepreneur are roles internal to the organization.Monitor and liaison are roles external to the organization.There are few topics in the field of project management that are so frequently discussedand yet so rarely agreed upon as that of project success. A review of the projectmanagement literature provides no consistent interpretation of the term project success.A framework called the square root consists of four success criteria. First, there are cost,time, and quality, which traditionally have been the easiest way to measure projectsuccess. The second success criterion is the outsourced service, the third is benefits for

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the client organization, and finally the fourth is benefits for the stakeholder community.A fifth success criterion can be added, in which the focus is on outsourcing implemen-tation. Hence, we apply the following five success criteria for IT outsourcing projectsuccess:

1. Project performance. This is the traditional evaluation criterion for project successconsisting of time, cost, and quality. The project has to be completed within thetime schedule and within the financial budget, and the technical requirements haveto be fulfilled.

2. Project outcome. This measurement is concerned with evaluation of outsourcedservices. Important dimensions for an IS include system maintainability, reliability,validity, and information-quality use.

3. Implementation. This is a criterion concerned with successful introduction,installation, training, use, and modification of the new IS environment. Importantdimensions include actual use and user acceptance.

4. Benefits for the client organization. Important dimensions of this success criterionare improved efficiency and effectiveness, increased profits, achieving strategicgoals, and organizational learning.

5. Benefits for the stakeholders. Important dimensions of this success criteria aresatisfied users, social and environmental impact, and personal development.

The five success criteria are illustrated in Figure 5.6. Project performance and projectoutcome are success criteria internal to the project. Implementation of outsourcing andbenefits from outsourcing are success criteria internal to the organization. Benefits forthe stakeholders are success criteria external to the organization.In the following, we will report empirical research aimed at identifying successfulmanagement roles for managers of IT projects. The following research question isaddressed: What management roles can predict the extent of IT project success? The

Figure 5.5. Management roles in IT outsourcing projects

ENVIRONMENT

CORPORATE BASE ORGANIZATION

CORPORATE PROJECT ORGANIZATION Leader role Resource allocator role

Liason role Monitor role

Spokesman role Entrepreneur role



research conducted by Karlsen and Gottschalk (2002) is important, because there are fewstudies of management roles in IT projects, and there is a lack of empirical researchmeasuring and explaining IT project success. One criticism of many studies is the poorlydefined success measures. In the present study, a project-specific typological approachwas used with a multidimensional criterion for assessing project success as illustratedin Figure 5.6, and a multivariate statistical analysis method.What kind of management skills is expected from project managers in today’s competitiveenvironment? Karlsen and Gottschalk (2002) formulated the following six researchhypotheses:

1. Total project success is related to the importance of the leader role. Certainly, theproject manager must take a leadership role. Leading is essential for projectsuccess. Leadership can focus on three levels—vision development, aligningpeople through communication, and motivating and inspiring subordinates. Fivetransformational factors can be highlighted—attributed charisma, idealized influ-ence, intellectual stimulation, inspirational motivation, and individualized consid-eration. Three transactional factors can be highlighted—contingent reward, man-agement-by-exception active, and management-by-exception passive. Transac-tional leadership alone can lead to low project success. Transactional leadershipneeds to be augmented with transformational leadership for high project success.Furthermore, troubleshooting and the project manager’s ability to handle unex-pected crises are critical success factors in the project execution phase. Hence, itis reasonable to hypothesize that project success depends on the leadership role.

2. Total project success is related to the importance of the resource allocator role.A characteristic of almost every project is scarcity of resources, such as human,financial, and information resources. This absence or shortage of resources makesthe resource allocator role an important project management function. During theproject period, the project manager frequently negotiates with the line organizationabout resource availability and utilization. This management role also includes

Figure 5.6. Success criteria IT outsourcing projects

ENVIRONMENT


CORPORATE PROJECT ORGANIZATION Project performance Project outcome

Stakeholder’s benefit

Implementation Benefits for client organization

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tactical activities such as planning and organizing of activities, which have beenfound to be critical for project success. Hence, it is reasonable to hypothesize thatproject success depends on the resource allocator role.

3. Total project success is related to the importance of the spokesperson role. As aspokesperson, the project manager has to take the end users’ and management’srequirements seriously, build a trusting relationship, and focus on implementationand use of the vendor’s services. Considering this management role, it can beargued that project success depends strongly on the end user’s involvement andacceptance of the solution as implementation concerns. Furthermore, client con-sultation and acceptance—a selling function—are of importance. Hence, it isreasonable to hypothesize that project success depends on the spokesperson role.

4. Total project success is related to the importance of the entrepreneur role. Thedriving force behind project initiation involves the end users’ needs. As anentrepreneur, it is the project manager’s role to identify users’ needs and thecorporate base organization’s requirements. Based on such needs and require-ments, the project manager is responsible for developing a fully acceptablesolution. If articulating needs is done insufficiently, the project will be initiated ona poor foundation, and major problems will arise when implementing outsourcing.The project manager is required to provide innovative solutions for both theproduct as well as the business processes involved in achieving the project’soutcome. Client consultation—a communication, listening, and feedback activ-ity—and client acceptance are critical project success factors. Hence, it is reason-able to hypothesize that project success depends on the entrepreneur role.

5. Total project success is related to the importance of the liaison role. Managementof stakeholders can be an important project management activity. It includesestablishing a trusting relationship between the project management and thestakeholders, which forms the basis for an exchange of information and resources.Project managers need to identify and interact with key institutions and individualsto reduce external risks. Hence, it is reasonable to hypothesize that project successdepends on the liaison role.

6. Total project success is related to the importance of the monitor role. Thechanging nature of the business environment during the project period makes thecollection and analysis of relevant information critical. The project manager isexpected to broaden the scope of environmental scanning and monitor the marketfor new technologies, new vendors, and new solutions. The critical role of themanager is to monitor the possibility of major technological changes by looking forsuch indicators as technical community disintegration, foreign invaders, newtechnology waves, and climate changes. To identify new ideas or changes fromsources outside the organization, a networking for interaction and communicationwith the market can be most helpful for the project manager. Hence, it is reasonableto hypothesize that project success depends on the monitor role.

A survey was conducted in Norway in 2001 to investigate these management roles. Atotal sample of 70 companies responded to the survey. On a scale from 5 (very important)to 1 (not important), the leader role achieved the highest score (4.3), followed by the



resource allocator role and the spokesperson role (both 4.0), the entrepreneur role (3.7),the liaison role (3.4), and the monitor role (3.1). Project success was measured on a scalefrom 1 (high success) to 5 (no success). Project outcome was the criterion, whichachieved the highest success (1.9), while benefits for the stakeholders was the criterionwith the lowest success (2.3).Hypothesis 1 predicts that total project success is related to leader role importance. Thestatistical results indicate a significant correlation between these two constructs,thereby providing support for this hypothesis. Also hypothesis 2 concerning theresource allocator role and hypothesis 3 concerning the spokesperson role weresupported in the research. Hypotheses 4, 5, and 6 were not supported in the empiricalresearch conducted by Karlsen and Gottschalk (2002).We have learned from this research that IT project managers are internally oriented. Itis our recommendation that outsourcing project managers may be more externallyoriented. It is always important that the project manager is goal oriented, but he or shemust not forget the client and the reason why the project was established. Through anexternal orientation, the project manager can improve the use of the project outcome andcontribute to value creation for the corporate base organization. Project stakeholdermanagement is also important to manage external disturbances and threats from actorsoutside the project.

Conclusions

IT is not just another resource that should be managed like any other resource. Managingsuccessful IT outsourcing implies that managers understand the specifics of any IToutsourcing candidate. Management has to understand the variety of IT activities,predict future needs, and understand IT economics. Furthermore, management has toidentify sourcing options and analyze opportunities and threats associated with each ofthem. Such analysis should take place within the framework of strategic IT planning.

Case Studies: Enter Strategies

Rolls-Royce conducted a capability study prior to the outsourcing. It may be regardedas a strategy process. Although none of the interviewees used the term “enter strategy”of what was happening at that point in time, the decision to outsource was regarded asa strategic decision. None of the interviewees were involved in the capability study, asthis was done many years ago and before the interviewees entered the companies. Thestrategic issues told to be underlying the outsourcing decision where costs, capabilities,and the need for a change agent. Rolls-Royce wanted a 10% reduction in IT costs. Thecriteria that were laid out for vendor selection was pretty clear around maximum servicelevels, around being able to handle large skilled contracts of that size, and around costs.EDS had generally been competitive on costs, and it demonstrated certainly that it could

Enter Strategy 153


provide capability for large-scale contracts. Rolls-Royce doubted it had the necessaryin-house capabilities to do the required step change from managing large mainframesystems to GUI-based client-server systems. A change required both human capabilitiesand financial capabilities to succeed. Rolls-Royce was looking for a company it mightdiscuss as the change agent, a company somewhat different to Rolls-Royce. It was notlooking for a traditional outsourcer, but a very service-oriented company. A majortransformation seemed to be a part of the plan, a transformation of Rolls-Royce from amanufacturing-oriented company to a service-oriented company. The culture that EDSwas bringing was part of what Rolls-Royce was looking for; a service-oriented, global,and people-oriented company.SAS outsourced for three main reasons. First, it wanted to benefit from the economiesof scale offered by an external service provider and to realize corresponding costreduction. Compared with other airlines the cost and efficiency of its internal IT groupwere far too high. Second, it wanted to lift its existing technologies to new platforms andreplace the old legacy systems with standard application in order to establish a more cost-effective platform. And third, it wanted to offer the employees in its internal IT groupbetter development opportunities for their professional careers. IT is the core compe-tence of CSC, but it is not at the core of an airline company. SIG management group andits chairman of the board took the initiative to start the process.Global IT management at ABB started to develop a strategy document before theoutsourcing, which later was signed by the management. It was never an outsourcingstrategy but a strategy for how to achieve a number of aims. It was at the time where ABBhad great financial difficulties. Because of this, cost reduction was a significant aim toachieve, and which provoked outsourcing. One of the things the CIO did was to spenda lot of time assuring that the countries in ABB were aligned to the outsourcing project.The starting point was a strategy document, but it ended up as a pure cost case, affectedby external environment. During the last few years ABB have been through severalorganizational changes. Focusing on two core business areas, power and automationtechnologies, it sold other businesses. But remaining internal functions were huge andinflexible. Simultaneously, the requirement from business unit areas was full transpar-ency regarding IT. ABB’s financial difficulties at that time and their restructuring aroundtwo core business areas pushed the IT to outsourcing.In all three cases, one important driver of outsourcing was cost reduction. According toneo-classical economic theory, companies will justify their sourcing strategy based onevaluating possibilities for production cost savings. Thus, the question of whether tooutsource is a question of whether the marketplace can produce product and servicesat a lower price than internal production. Client companies reported reduction of costs,better cost performance, and better economies of scale, compared to internal IT function.As one senior client manager stated, “We were under financial pressure, and our bankerspushed the outsourcing forward.”But costs were not the only reasons for the client companies. New business strategiesand restructuring of client companies were also important drivers. ABB was restructuringaround two core business areas, and SAS admitted that IT was not at the core of an airlinecompany. Core competencies theory suggests that activities that are not core competen-cies should be considered for outsourcing with best-in-the-world suppliers. Theiroutsourcing vendors, IBM and CSC, respectively, have IT as their core competence.



The ability to handle technological change was also reported as a major issue foroutsourcing. Both Rolls-Royce and SAS had a challenge, handling both cost reductionand new technologies at the same time. According to the resource-based perspective,outsourcing is a strategic decision that can be used to fill gaps in a firm’s IS resourcesand capabilities. In the case of Rolls-Royce and SAS, it was a difference between desiredcapabilities and actual capabilities. Interesting to notice, the transformation of Rolls-Royce from a manufacturing-oriented company to a service-oriented company seemedto be a part of the plan. Vendor resources can produce innovation, which might beimportant for long-term survival of the client. In this specific case, the vendor’s abilityto do change agentry was an important criterion for vendor selection.

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Chapter VI

Phases and Activities

Lacity and Willcocks (2000a) identified six outsourcing phases. In these phases, a varietyof stakeholders are involved, such as customer senior business managers, customersenior IT managers, customer IT staff, IT users, supplier senior managers, supplieraccount managers, supplier IT staff, and subcontractors. Stakeholder relationships varyduring activities within phases, depending on goal alignment. For each of the phases,Lacity and Willcocks (2000a) defined the major stakeholder goals, interactions, andoutcomes witnessed in practice.

Phase 1: Vision

The customer goal in this first phase is to create a strategic vision of IT sourcing. Thetwo main activities in this phase are identifying core IT capabilities and identifying ITactivities for potential outsourcing. Typically, the customer senior business managersand customer senior IT managers are the primary stakeholders involved during this initialphase. Senior business managers have agendas prompted by financial pressures. Suchpressures often lead to a core competency strategy by which the organization focuseson the core and downsized or outsourced rest. Because many senior business managersview much of IT as a noncore competency, they regularly question whether some or allof the IT function can be potentially outsourced.Senior IT managers have typically coped with a legacy of trying to balance serviceexcellence demands from the user population with IT cost-containment pressures fromtheir senior managers. In the past, there was always tension between CEOs and seniorIT managers because the latter often struggled to demonstrate value for IT expendituresto their bosses. A full-blown investigation of IT sourcing options, however, often serves



to align goals between senior business and IT managers. Because senior IT managersrarely loose their jobs as a consequence of outsourcing, they usually welcome a reasonedapproach to sourcing the IT function. With the support of their bosses, senior ITmanagers can overcome user resistance and implement cost-reduction and outsourcingstrategies.Supplier stakeholders are not typically involved until the evaluation phase. However, insome cases, supplier senior managers may actually be the ones prompting the decisionto consider outsourcing by wooing customer senior executives in this phase.Customer and supplier senior executive interactions are typically characterized bytentative enthusiasm and optimism during the scooping phase. But one lesson thatclearly emerged from Lacity and Willcocks’s (2000a) research was that customer andsupplier senior executives should not make outsourcing decisions without ITmanagement’s input. The “CEO handshake deal” typically fails because of inattentionto detail. CEOs can get excited about an alliance, but the success of IT outsourcing dealsrelies on the details of the cost and service to be delivered.

Phase 2: Evaluation

The customer goal in this phase is to identify the best source for IT activities. The majoractivities during this phase include measuring baseline services and costs, creating arequest for proposal, developing evaluation criteria, and inviting internal and externalbids.There is a need for joint senior management and IT management participation in sourcingevaluations. The evaluation process that frequently leads to success includes creatinga request for proposal and inviting both external and internal bids. This practice ensuresthat a supplier’s bid is not merely compared with current IT performance but with ITperformance that could be achieved if internal managers were empowered to behave likesuppliers.Supplier stakeholders become much more active during this phase. In addition to thesupplier senior management team, a host of supplier experts may attend bid presenta-tions. While the supplier representatives talk to senior business managers aboutfinances, they also talk to users about service, to the IT staff about career paths andbenefits, and to IT managers about baseline service-level agreements.As with the previous phase, the customer–supplier interactions, although tentative, aretypically characterized by enthusiasm and optimism at the senior management levelduring the evaluation phase.The customer IT users are primarily concerned with service excellence during the entireoutsourcing evaluation. IT users sometimes question confidentiality and privacy of datawith IT outsourcing. But in general, IT users typically support outsourcing because theyperceive that suppliers, with their IT expertise, will increase service and provide new ITto the user community.



At the customer IT staff level, however, IT professionals are frequently threatened bythe impending decision. Some organizations, particularly those with an IT labor union,experience significant resistance from this stakeholder groups.In cases in which IT staff is invited to submit an alternative bid, the internal bid processoften serves as a galvanizing force. In some cases, senior management grants a requestfor an internal bid more as a morale preserver than as a serious contender against externalbidders. Once given free rein to compete based on cost efficiency, internal IT managersmay surprise senior management by submitting the winning bid. Sourcing evaluations,which lead to continued insourcing of the IT function, then proceed to a transition phase.The primary activity of the insourcing transition phase is the implementation of consoli-dation, rationalization, and standardization of the internal bid proposal.Sourcing evaluations that result in outsourcing typically proceed through the fouradditional phases whose description follows. Unlike insourcing, IT outsourcing requiressignificant changes in duties and responsibilities of IT management, staff, and users.Also, more stakeholders must adapt and learn to interact with each other to deliver a cost-effective IT service.Information security considerations belong in the evaluation phase. Khalfan (2004)notes the importance of addressing information security within the context of IToutsourcing contractual relationships. Once an organization has handed its computerapplications over to a vendor, its biggest concern includes who is handling andaccessing the data and what guards the networking connection from outside. Outsourcingsecurity services is a contentious issue because organizations are hesitant to entrust ITservice providers with the keys to their IT systems and data.Information security can be defined as integrity (gathering and maintaining accurateinformation and avoiding malicious modification), availability (providing access to theinformation when and where desired), and confidentiality (avoiding disclosure tounauthorized or unwanted persons). The degree to which these aspects are preservedin an outsourcing arrangement must be based on the business’s security requirements.This can be properly understood through accurate risk and impact analysis, as securitymanagement is concerned with addressing activities that are required to maintain risksat a manageable level (Khalfan, 2004).

Phase 3: Negotiation

The customer goal in this phase is to negotiate a contract to ensure sourcing expectationsare realized. The following activities may be included in this phase: conduct due diligenceto verify claims in the request for proposals, negotiate service-level agreements for allIT services, create customer–supplier responsibility matrixes for all defined responsibili-ties, price all defined units of work, negotiate terms for transfer of employees, and agreeon mechanisms for contractual change, including benchmarking, open-book accounting,nonexclusivity clauses, and pricing schedules.Contract negotiations are typically antagonistic because the customer stakeholders andsupplier stakeholders are both accountable to protecting the interests of their respective



organizations. Participants may use nouns such as war, bloodbath, and battle to describenegotiations. No parties, however, seem to expect a different type of relationship duringcontract negotiations. Each side expects the other to be a tough negotiator. Duringoutsourcing negotiations, customer IT managers are typically tough negotiators. Theyfight very hard to represent the interests of their organizations. Tough battles duringcontract negotiations between customer and supplier constituents often lead to suc-cessful arrangements. After a contract is signed, however, the customers and suppliersseek a more harmonious relationship.IT users are another stakeholder group involved in contract negotiations. Because IToutsourcing contracts typically rely on a baseline measure of services, users becomeinvolved in documenting current service levels and volumes. IT users are generallymotivated to inflate current service levels. In essence, this will enable them to get thesupplier to increase service levels under a fixed-fee baseline price. But suppliers may bekeenly aware of the motivation and therefore require a documented and detailed duediligence process to verify baseline claims.During the negotiation phase, the customer stakeholders often interview potentialsupplier account managers. Initial meetings are often characterized by tentativeness aseach party explores the other’s motivations and values. Customer stakeholders aremotivated to select a person who will primarily focus on customer service. Supplierstakeholders—who are accountable to their shareholders—need a person who willprotect their profit margins. In some cases, customers will not select a person who is partof the supplier negotiating team. When a customer experiences a supplier’s toughnegotiating skills firsthand, it naturally retreats from the individual. Instead, a fresh faceoften helps the transition from antagonism during the negotiation phase to cooperationduring the transition phase.In general, all parties agree that even though contract negotiations are antagonistic, theprocess is worthwhile for both sides. Detailed contracts document expectations and aretherefore a prerequisite for a successful relationship.

Phase 4: Transition

The customer’s goal in this phase is to establish precedents for operational performance.For large contracts, transition activities may last from 18 months to more than two years.Lacity and Willcocks’s (2000a) research shows eight main areas of activity here, asdetailed below:

• Distributing the contract. Many actual IT outsourcing contracts are impossibleto execute because they are typically massive documents written in obscure legalterminology. It may be necessary to develop user guides to the contract, which aredesigned to describe what the supplier is obligated to provide under the fixed-feestructure in user terms.



• Interpreting the contract. No matter how well the negotiating teams believe theyhave nailed down the details, the contract is always open for interpretation.Typically, the customer IT managers and supplier account managers are in chargeof resolving contract interpretation issues.

• Establishing postcontract management infrastructure and process. Customersusually establish a centralized team to facilitate strategic and financial monitoring,and decentralized teams to monitor operational service levels. For problem resolu-tion customer and vendor must cooperate and thus they often establish commonprocedures, which are documented in handbooks. Decentralized teams are com-posed of customer IT staff, customer IT users, and supplier IT staff, and the goalof the joint team is to resolve problems before escalating the issue to their superiors.

• Implementing consolidation, rationalization, and standardization. Suppliers’bids are often based on cost-reduction tactics, such as consolidating data centers,standardizing software and hardware platforms, centralizing IT staffs, and so on.Implementing these projected savings might be unpopular among IT users. Thesupplier needs the savings to earn profit on the account, and it has the power toovercome user resistance to cost-reduction tactics.

• Validating baseline service scope, costs, levels, and responsibilities. One majorchallenge for the relationship is validating the baseline. Suppliers’ bids are basedon the request for proposal and discoveries made during due diligence. Failure tomeet the agreed-upon service levels can result in financial penalties.

• Managing additional service requests beyond baseline. Service beyond baselinecan be triggered by exceeding projected volumes on existing services, changingthe composition of baseline services, and by demanding entirely new services. Byits nature, long-term outsourcing contracts will have to meet these kinds ofrequirements and changes.

• Fostering realistic expectations of supplier performance. IT users often havemisperceptions about what the supplier is obligated to provide the customer. Bothcustomer IT managers and supplier account managers share the goal of communi-cating contractual obligations to the IT user community.

• Publicly promoting the IT contract. Both customer senior managers and suppliersenior managers will often jointly explain the benefits of the relationship to bothorganizations. Although both sides admit that relationships are not always easy,customers and suppliers stress the overall value to the organizations.

Phase 5: Improvement

The customer goal in this phase is to achieve value-added above or beyond operationalperformance. Customers seek to adapt and to improve the contract beyond the baseline.Cost reduction, service improvement, and more strategic views of IT service delivery aresought. The major activities in this phase include benchmarking performance, realigningthe contract, and involving the supplier in value-added areas. Because of the history of



working with the supplier, parties during the middle phase are typically comfortablechanging hats from adversaries to cooperators to collaborators, depending on the taskat hand. By the middle phase, the complexity of relationships has become second nature,although the relational climate depends on how the overall outsourcing arrangement isturning out. In this middle phase, three activities dominate:

• Benchmarking performance. Benchmarking is the practice of comparing a customer’sIT performance against a reference group of similar organizations. In this phase,benchmarking is used as a tool to ensure that the supplier’s cost and services areamong the best of breed. Customers view benchmarking as a powerful tool toleverage their bargaining position with the supplier. The major stakeholdersinvolved in this activity are the customer IT managers and the supplier accountmanagers.

• Realigning the contract. Customers frequently find that the original contractbecomes obsolete as technology advances, business requirements change, andfalse assumptions become illuminated. During a contract realignment, customer ITmanagers and supplier account managers are the most active stakeholders. Stake-holder goals are in conflict because each side is motivated to protect the interestsof its own organizations. By this stage in the relationship, however, relationshipshave progressed beyond the tentativeness of original contract negotiations. Thecustomer and supplier constituents have a history of working together, and bothare committed to perpetuating the relationship.

• Involving the supplier in value-added areas. The primary focus of the transitionphase is to establish operational performance. Customer and supplier stakeholdersseek ways to extend the relationship into more value-added areas. Value-addedareas may include the following: supplier participation on steering committees,selling customer IT assets and jointly sharing profits, and supplier participation onbusiness process reengineering projects.

According to Morgan (2003), benchmarking is about objective analysis of processes tomeasure the gap between industry best practice and current performance. It can be usedprior to outsourcing to act as the measure against which the service provider mustperform, or as the postdeal measure to show over the lifetime of the contract how wellthe service provider is performing relative to accepted norms or indices. Benchmarkingwithin any business support service is a set of processes, options and procedures thatgenerate confidence for the customer that the supplier is meeting the service objectivesat a performance and cost consistent with market best practice. Commercially availablebenchmarking falls into two major categories: metrics and research-based benchmarking,and commercial benchmarking.Metrics and research-based benchmarking is done against a basket of remote andabstract research into those elements of the service that can be delivered as commodity.Commonly such basket benchmarking compares clients within the same industry sectorand therefore reflects aspects such as buying power and commercial savvy rather thanthe value derived from services, although it is not uncommon for clients to be compared



with companies from other industries in different countries and even different conti-nents. Commercial benchmarking is an alternative form of study that looks in detail at thespecifics of the supplied services in the context of both the service objectives and themarket for supply. Not abstract or research led, it therefore requires specific practitionerknowledge and experience to achieve value (Morgan, 2003).

Benchmarking

According to Lacity and Hirschheim (1995), benchmarking can be a strategy for managingconflicting stakeholder perceptions of IS. One important stakeholder is senior manage-ment, and senior management is often frustrated with IT performance. Seniormanagement’s view of IT is often to minimize costs of IS. All senior management typicallysees is the amount of money that they have to write a check for every year. They viewIS as a commodity and/or overhead. As such, they set the IS strategy to be costminimization, and in general perceive that IS managers have failed to meet this majorobjective. Senior management sends the mandate to IS managers: cut IS costs.To respond to this mandate, some IS managers call outsourcing vendors to test the marketor conduct formal outsourcing evaluations to assess and improve IS cost effectiveness.The formal approach is by far the most rigorous way to benchmark, and it entails creatinga request for proposal (RFP), soliciting vendor bids, and comparing bids against internalcosts. Senior management tends to view this source as the most reliable because itcompares apples with apples and requires bidders to commit to their costs. Outsourcingevaluations, however, are extremely disruptive to other stakeholder groups. Users oftenrally against outsourcing, preferring their own familiar IS managers, regardless of theirperceived performance, to the uncertainty of vendors. Within the IS organization, rumorsof outsourcing evaluations detrimentally affect employee morale. Consequently, formaloutsourcing evaluations may be a poor source of benchmarks if the organization merelywants to assess performance.To obtain valid benchmarks, Lacity and Hirschheim (1995) suggest a framework to serveas a discussion tool for stakeholders within organizations to understand the root of theirdifferences, and to make strides toward shared objectives for various IS activities.Perhaps senior managers can convince users that data centers are a commodity and thatcost efficiency is the appropriate strategy for this function. Perhaps users can convincesenior management that certain applications must be customized to meet critical businessneeds and that service excellence is the appropriate strategy for this function. Theimportant thing is to agree on IS priority that makes business sense, then selectbenchmarks targeted to meet the cost/service trade-offs suggested by the strategydefined. The framework suggested by Lacity and Hirschheim (1995) consists of thefollowing eight critical success factors:

1. Align performance expectations for the IS portfolio based on business contribu-tion. When classifying different activities into commodities and differentiators,stakeholders must ignore conventional arguments and generalizations and mustnot let the accounting structure mark IS’s business value.



2. Select a family of measures suggested by the IS strategy. Through the process ofalignment with business strategy, a portfolio of strategies for IS will emerge for theIS portfolio. Typically, the performance objective for differentiators is serviceexcellence, while performance objective for commodities is typically cost minimi-zation.

3. Secure stakeholder participation in the selection of benchmarks. Stakeholderssuch as senior management may not attend to benchmarking results because thebenchmarks are not viewed as objective. If they are not involved, stakeholdersmistrust benchmarking results.

4. Select the reference group that represents the stiffest competition possible.Stakeholders are most impressed by benchmarks against the stiffest competition,such as best of breed within an industry.

5. Select the reference group based on criteria important to strategy. Benchmarkingservices can select reference groups based on size, geographic area, industry, orother criteria. Reference group selection should be based on the business strate-gies and concerns.

6. Ensure integrity of the benchmarking process. To ensure valid benchmarks,stakeholders can demand that the benchmarking service does not manipulate theirnormalization process, the benchmarking service presents results in well-designedreports, senior level people gather the data, and the benchmarking service con-ducts a data validation meeting.

7. Use benchmarks not as a report card, but to identify improvements. The bestevidence in favor of benchmarking for improvements is from companies thatactually used the benchmarking service to identify and improve performance.

8. Repeat benchmarks. Senior executives tend to place more validity in benchmarkingresults if measures are repeated periodically. While senior executives favorablyview positive benchmarks, they are more concerned that IS managers improveperformance over time.

Phase 6: Mature

The customer goal in the mature phase is to determine and plan for the fate of currentsourcing options. During the mature phase, the customer’s goal is first to ensurecontinued operational performance if the relationship is not to be renewed. Whenrelationships are extended, the mature phase provides an opportunity to learn from pastexperiences as well as to explore creative options when constructing a new deal.Assessment of these options depends as much on business strategic concerns and thenature of the current and future competitive climate as on the strength of relationshipsand past value of the outsourcing arrangement. Although only a few of our long-termdeals have reached this stage, two activities are apparent:



• Recalibrate investment criteria. When suppliers make IT investments on behalfof a customer, the supplier needs time to recoup the investment. As the contractreaches the expiration date, reinvestment becomes a major issue. The suppliers willnot want to invest in new capital assets if the customer decides not to extend therelationship.

• Determine whether relationship will be extended or terminated. Some companiesare so concerned about what happens at the end of contracts that they avoidoutsourcing altogether. In a current outsourcing relationship, three options arepossible: extend the contract with current supplier(s), switch supplier(s), or bringthe IT activity back in-house. Lacity and Willcocks (2000b) find in their survey thatall three options are commonly practiced in the United States and the UnitedKingdom: 51% switched supplier, 34% brought the activity back in-house, and 11%renewed the original contract.

Winner’s Curse

Selecting the right IT supplier, on the right terms, poses an ongoing challenge. Thedifficulty frequently lies in choosing the evaluation criteria that satisfy the clientorganization’s objectives for outsourcing in the first place—commonly those benefitsthat the internal IT organization is not able to deliver but that the supplier(s) can offer.The major criteria have been identified as financial, business, technical, strategic, andpolitical benefits. The most common benefits sought are financial, typically representingcost savings of 10–40%, improving cost control and clarity, and increasing cash flow.Business, strategic, and political benefits have involved new business start-ups,process reengineering, a refocus on the client’s core competencies, assisting in manag-ing mergers or globalization, and diminishing the often political debates about new ITprojects. Finally, the technical benefits commonly offered have included access toexpertise, improved services, new technologies, and technological innovation (Kern etal., 2002).Selecting a supplier is a costly undertaking in terms of time, effort, and resources.However, the investment in identifying the right supplier and contract bid is paramountto the success of the overall outsourcing venture. Practice shows that customers willoften choose suppliers on a subjective basis informed by qualitative issues, especiallywhere the quantitative assessment is more or less the same for all bids. Additionally, poorin-house evaluations of costs and services by customers may also mean that overprom-ising by suppliers will be initially accepted as a superior bid. In either circumstance, aWinner’s Curse scenario becomes more probable.According to Kern et al. (2002), the Winner’s Curse occurs when the winner of an auctionor bidding event systematically bids above the actual value of the objects or service andthereby systematically incurs losses. Acceptance of a bid in general is an informativeevent, and the failure to incorporate such contingent information into the biddingstrategy can lead to excessive bids and subsequent losses for both parties. The dangerof a Winner’s Curse arises in IT outsourcing as suppliers make unrealistic bidding



promises to ensure they win the contract, but already know, or subsequently discover,that they are unable to recover their tendering, business, and operational costs for thenear future. Instead, suppliers take a risk in hoping that they can recover their costs by,for example, identifying service areas that are in need of urgent attention and/or areasof immediate service provision that are excluded from the contract but are neededoperationally, so meriting excess fees. In addition, suppliers will attempt to offeradditional services from their portfolio of technology capabilities, service management,and consultancy services over the life of the contract.The outsourcing selection and bidding process has strong similarities to auctionsituations. In IT outsourcing, various suppliers may be asked to bid to provide ITservices. The likely danger is that suppliers can outbid themselves and subsequentlyfind it impossible to continue with the deal as priced and structured. In a Winner’s Cursesituation, the relationship is likely to suffer severely due to the supplier’s miscalcula-tions.The experience of a Winner’s Curse places considerable pressure on an outsourcingventure and relationship to the point where renegotiation or early termination becomesthe only options. Active relationship management by competent relationship managerscan facilitate a successful turnaround of such a venture. However, regardless of whetherthe venture is saved, significant costs will arise for both parties, raising general doubtsover the financial viability of such deals in general. Understanding how such scenarioscan evolve is starting point for avoiding a Winner’s Curse experience (Kern et al., 2002).

Conclusions

Managing successful IT outsourcing requires a systematic approach in terms of phasesand activities. Relevant phases will depend on the situation of both potential customerand potential vendors, but a starting point includes the six phases of vision, evolution,negotiation, transition, improvement, and performance. For potential vendors, avoidingthe winner’s curse is important.

Case Studies: Relationship Phases

The six relationship phases are discussed in this section as they were recognized at thethree international-based IT outsourcing relationships studied.

Rolls-Royce—EDS

Prior to outsourcing, there was a capability study of the IT function of the company,identifying core competence and activities. This study raised doubt of the in-house ITfunctions ability to handle the challenges of the company. This was the scooping phase,



establishing a goal or vision for the outsourcing. Evaluation and negotiation phases werelimited in a time perspective. Rolls-Royce went through a very standard procurementprocess of defining all the pieces that needed to be outsourced defining what wasrequired, and then inviting bids to the standard request for proposal (RFP). All the bigplayers, external outsourcing vendors, were involved in the bidding. The first contractwith EDS, the one for the aerobusiness, was negotiated in 1996. The second contract forthe industrial business was signed in 1997. The goal of these phases was first to selectthe best vendor and then to sign the contract.In the transition phase the major goal of the two parties was to establish agreed-uponoperational performance. After the contract was signed, there was a “honeymoonperiod,” where the outsourcer gave Rolls-Royce “anything.” The outsourcer put a newdesktop in, because it was more efficient and because the outsourcer has the know-howto standardize. The users got lucky; they got something quick and sexy, and faster thanwhat the IT department could deliver. The IT department thought they had got a partnerit could manage and control. All major IT assets and more than a thousand people gottransferred to the outsourcer.As service levels were established, the parties moved into the improvement phase, wherethe overall goal was to achieve value-added services above operational performance.The issue arose when Rolls-Royce started to add new services and remove old servicesfrom the original contract. Rolls-Royce had to pay extra for everything, and the partieshad to refer to the contract, and they started quarrelling. Rolls-Royce merged theaerobusiness and the industrial business, and in 2000 it had to realign the contracts toreflect changes in technology, services, and business. The original contracts were madea “foot” thick. Then in 2000, it tried to make the contract a trusted one, and it actually wentto buy services. It was widely reported that it was a £1.3 billion deal over 12 years.

SAS—CSC

In the scooping phase, SAS used business, economic, and technical criteria to identifypotentials for outsourcing. As part of the company’s huge cost-reduction program, thegroup looked at all kinds of costs, including IT costs. SIG was at that point of time alreadya stand-alone company, wholly owned by it largest customer SAS. The management ofSIG looked at different scenarios for survival, one of which was to sell the company toan external service provider. This way, SIG could continue to serve its largest customer,and with possibilities of gaining large-scale opportunities and access IT capabilities. SIGmanagement meant an outsourcer would be a better place for SIG employees. Thus it madea suggestion to its board of directors to sell the company. Selective outsourcing was alsoconsidered, but it concluded that selective outsourcing would require too much manage-ment attention.The objective of the evaluation phase was to select the best and final offer. SAS boardof directors decided in August 2003 to start the process of selling SIG and to establisha frame agreement for buyback of services. First step was to develop an informationmemorandum describing SAS’s IT governance structure, including a description of SIGas a company in terms of economic conditions, assets, and management. An investment



banker was also chosen a short time after the decision, and which handled the formalitiesof the bidding process. Many vendors signed the confidentiality statement and theyreceived the information memorandum. A few of these vendors delivered a nonbindingbid. All the Nordic vendors quitted, first of all because of the size of the deal. The steeringcommittee decided which vendors should be invited to give binding bids. One of thesevendors quitted and one of them was taken away. SAS started negotiation with twovendors. Important evaluation criteria were economy, financial strength and persever-ance of partner, sensitivity to SAS’s proposed conditions, and handling of SIG person-nel. By December 18, 2004, the outsourcing agreement between SAS and CSC was signed.Due to the fact that SIG was a stand-alone company, it was delivering services to SASon already-established agreements, and thus the evaluation and negotiation phasescould be done in a relatively short amount of time. The outsourcing deal was partly atakeover, and partly a buyback of services. Technically, the transition of shares tookplace on February 1, 2004. And by this transaction, SAS was transferring IT assets,leases, staff, and management responsibility for delivery of services from an internal ITfunction to a third-party vendor. About 1,100 employees got CSC as a new employer.Intellectual property rights for business applications were kept in SAS.As SAS had already been treating SIG as an external supplier, the scope, costs, levels,and responsibilities of the baseline services were already established and were notchanged very much. There had been some disagreement around contractual interpreta-tion, but no serious problems. Thus, the objective of the transition phase, to establishoperational performance, was relatively straightforward. Transforming SIG into CSC’sglobal operating model was, however, a huge program involving many people from thevendor organization. Although operational performance was not affected, the internalfocus of the transformation period takes focus away from value-added services.

ABB—IBM

In the scooping phase, ABB identified IT activities for potential outsourcing. Although,ABB global senior IT management set forth to create a strategic vision of IT in thecompany, the IT sourcing decisions ended up as a business decision. As the overallorganizational goal was to cut costs, there was also a pressure for significant costreduction within IT. A few months later, close to 90% of ABB’s IT infrastructureoperations where outsourced to IBM, including more than 1,200 employees in 14 differentcountries.In the evaluation phase a few potential suppliers were invited to bid for the infrastructureoperations. There were not many service providers that could deliver services to a largenumber of locations in many different countries. ABB was aiming for competition, butone service provider after the other dropped out. In ABB’s opinion one service providerwas not capable of delivering the required services at that time, and it was also notfocused sufficiently hard on cost reduction. It was disqualified. Another one declinedto bid, because it did not believe its chances of success was high enough to justify theinvestment in bid time and quest. A third one was interested enough to make theinvestment on trying to win the business, but it needed to know ABB as an organization.Due to the very difficult financial situation in the company, it was difficult for ABB’s



senior executives to spend time with the service provider. Thus ABB lost the thirdpotential bidder. ABB already had a long-standing relationship with IBM. A pilotoutsourcing to IBM in Sweden and India 12 months before was at that time goingreasonably well. And thus, IBM was selected as the best and final offer.Negotiation was done in two major areas. The first element was the core contract, whichwas the core service specification. This was negotiated and developed centrally by aglobal team. The other element was that the ABB countries negotiated their own versionsof the contract, underlying the core documents. During the local negotiations, changesto the standard documents were kept at a minimum. This was done to obtain economiesof scale. One basic country contract was negotiated globally, with very small countryvariations. Global sign-off of the agreement was done on July 28, 2003. Countryagreements were signed locally. Transfer of responsibilities took place in September2003. It was a 10-year contract helping ABB significantly reduce costs.In the transition phase, the main focus was to establish agreed-upon operationalperformance, including consolidation, rationalization, and standardization of infrastruc-ture (and this continues to this day). Another important issue was to establish apostcontract management infrastructure and processes. A relationship alignment projectbetween the ABB team and the IBM team was set up to take care of this.



Chapter VII

Contract Development

According to Graham (2003), one of the games lawyers play in negotiation meetingsrelating to outsourcing is to bet how long it will be until one party describes theoutsourcing as a “partnership.” Nothing could be farther from the truth: the parties’interests overlap, but they are not congruent, and neither party will put its existence onthe line for the other. A relevant approach in contract negotiations is to see theoutsourcing as the creation of a long-term, flexible relationship, but one that exists withina framework of rules that support its success while addressing failures practically. Thecontract, therefore, has a sophisticated role not only as the passive record of the parties’agreement, but also as the guidebook for the evolving transaction.This chapter considers the structure of the contractual documents and the key issuesthat need to be reflected in them. Elizur and Wensley (1998) apply game theory in theirstudy of IS outsourcing contracts. They find six typical issues arising in an outsourcingsituation: the transfer of IS assets, risk sharing, technology upgrading, contract dura-tion, relationship management, and fee arrangements. In addition, we have added theimportant topics of due diligence and dispute resolution. We will consider each of theseissues separately after our discussion of contract structure.

Contract Structure

The shape of the deal should determine the contractual structure, rather than the otherway round. However, it is tempting to see the contracts as the checklist for the dealwithout first considering the drivers for the structure of the arrangements. The simpleststructure assumes that there will be a monolithic company outsourcing a technologyfunction to a monolithic service provider. This could be dealt with in just one contract,

Contract Development 169


but for convenience, the one-off provisions relating to the transfer of assets and peopleare usually split out into a separate agreement, as illustrated in Figure 7.1. By one-off itis meant that the transfer of assets and people occurs only once, while services andpayments occur on a continuous basis as long as the outsourcing arrangement lasts.However, the outsourcing organization is often a group of companies with the contract-ing party, either a parent or a procurement company, buying services on behalf of thegroup. The group itself may be spread over a number of countries. Furthermore, theoutsourcing organization may be taking the services in order to supply elements of themon to its customers, for example, if it is buying call center services. The scope of interestedparties on the user side of the equation, therefore, may well extend beyond its corporatefamily. Also, the provider may be contracting to provide the services using members ofits group and also subcontractors outside that group. Finally, the parties may want toexplore other structures, such as the creation of a joint venture.The documents encapsulating an outsourcing agreement do reflect the structure of thedeal. At their simplest, though, there are two principal contracts: the transfer of assetsagreement and the outsourcing services agreement (Graham, 2003):

• The transfer of assets agreement exists to affect the instant transfer of the assetsand then has no continuing role and can fall away. However, while a purchaser ofa business will need to bear the future investment costs in replacing assets, in anoutsourcing both the up-front and continuing costs will generally be amortized bythe provider over the life of the outsourcing and be reflected in its charges to theuser.

• The services agreement deals with the long-term relationship between the parties.In doing so, it has to achieve the following: define the services that are to beprovided and the standards they are to meet; describe how the services are to beimplemented, if there is any transition or migration of the services from the premisesor platform of the user to that of the provider; provide for any dependencies on theuser; set out a framework for changing the services over time; deal with failures toprovide the services to the service standards; allocate risk and reward; establisha basis for communication, liaison, and the escalation and resolution of disputes;determine the ownership of intellectual property created as part of the services;permit the user to verify that it is getting value for money; and allow the user toretender the services and to exit the contract smoothly.

Figure 7.1. Transfer of assets and provision of services in outsourcing (Graham, 2003)

Outsourcing customer as services user

Outsourcing vendor as services provider

Assets transfer

Payments made Services provided



Structurally, the services agreement consists of the terms and conditions and a seriesof schedules that contain the technical, commercial, and operational details. This notonly makes navigation around the document relatively straightforward, but it also aidsthe negotiation process by allowing the streaming of consideration of the variousaspects of the document. The danger of this, however, is that the services schedule (inparticular) is seen as being a separate agreement, a mistake often encouraged by itstypical designation as the service-level agreement (SLA). The SLA must be seen as anintegral part of the legal documentation. Properly considered and drafted agreements arean essential prerequisite to a successful outsourcing relationship. It is important to avoidthe “kitchen-sink approach” to drafting: contracts that amount to hundreds of pages andattempt to preempt all eventualities end up being self-defeating and unusable in practice.Furthermore, it is important to face up to unpalatable issues and address them directlyin the contract; these include how disputes are to be dealt with and risks allocated.Finally, it is important to support the relationship by building a flexible framework ratherthan a contractual straightjacket (Graham, 2003).

Asset Transfer

When IS are outsourced, it is often the case that specific assets are actually transferredto the company providing the outsourcing services. This transfer provides benefits toboth the outsourcing company and the outsourcing vendor and may also mitigate thepotential dilution of the bargaining power of the outsourcing vendor. From the stand-point of the outsourcing company it is able to “sell” specific assets for significantly morethan they would be worth on the open market. Hence the company is able to recapturesome of the specific value of these IS assets. The outsourcing vendor is able to obtainspecific assets that would normally be difficult, if not impossible, to obtain otherwise.Finally, the threat of renegotiation by the outsourcing company is made less credible tothe outsourcing vendor because it can be matched by a threat by the outsourcing vendorto withdraw services. By giving up its specific IS assets the outsourcing company makesitself vulnerable to renegotiation threats from the outsourcing vendor since it may wellnot be able to obtain information services from any other vendor (Elitzur & Wensley,1998).A difficulty arises for the outsourcing company as the result of significant asset transferwhen it comes time for contract renewal. In transferring assets the outsourcing companygives up specific assets and competencies. As a result of this transfer, the outsourcingcompany weakens its bargaining position when it comes to the renewal of the outsourcingagreement. In order to address this concern, there are a number of actions/commitmentsthat the outsourcing vendor can make to assure the outsourcing company that it will nottake advantage of its position. One possible action is for the outsourcing vendor toensure that a standard system is developed to replace the outsourcing company’spresent proprietary system. This ensures that there will be some competition with otheroutsourcing vendors at renewal time and in effect is similar to a component supplier withproprietary technology licensing its technology to other suppliers to reduce what isoften termed the holdout potential. Although such system standardization may or may



not be requested by the outsourcing company, it can clearly be used as a signal to theoutsourcing company that the outsourcing vendor does not intend to take advantageof its knowledge and expertise. If the outsourcing vendor is simply providing supportservices while the outsourcing company makes the transition to a new hardware andsoftware platform, this situation does not arise (Elitzur & Wensley, 1998).Another way of assuring the outsourcing company that it will not abuse its power atcontract renewal time is for the outsourcing vendor to agree to retrain the necessary staffif the outsourcing company seeks to bring IS back in-house at the end of the contract.

Risk Sharing

The sharing of risk between the outsourcing company and the outsourcing vendor hasa direct impact on the payoffs available to each party. By reducing the risk to which theoutsourcing company is exposed the payoff for a particular alternative is increased fromthe outsourcing company’s perspective. This may lead the outsourcing company toconsider an alternative that it would not have considered in the absence of some typeof risk sharing.IS are subject to a variety of different types of risk. The types of risk that will be relevantto an IS outsourcing arrangement will vary depending on the nature of the products/services covered by the arrangement. For example, in cases where IS development isoutsourced, the types of risk are often identified as financial risk, business risk, andtechnical risk (Elitzur & Wensley, 1998):

• Financial risk refers to the possibility of financial loss. No IS project yields certainreturns or has costs that are known with certainty beforehand. Researchers in thefield of finance have demonstrated that there are two key components of financialrisk: systematic and unsystematic risk. Systematic risk is the risk associated withthe project itself, whereas the unsystematic risk is risk that can be diversified away.A small or medium-size company may not be able to diversify away the unsystem-atic risk associated with a project. In this case, the company may be motivated toemploy an outsourcing vendor because the reduction of overall risk associatedwith a project has the effect of increasing the value of the project. The relative powerof the two parties entering into an outsourcing agreement will be an important factorin determining how the increased value is distributed between the parties.

• Business risk refers to the possibility that the business opportunity for which aparticular application is being developed either fails to materialize or generates afar lower revenue stream than expected. It is interesting to note that the likelihoodthat a system fails to deliver expected returns depends on many factors, not leastof which are the effort and skill of the outsourcing vendor, the effort of theoutsourcing company, and the extent to which the two communicate effectivelywith each other and many other stakeholders. It would make sense for theoutsourcing vender to be exposed to some of the business risk otherwise he/she



has less incentive to produce and run a viable system. To this end, it is suggestedthat the contract includes performance characteristics broadly related to thebusiness value of the system and the extent to which it provides value to the variousstakeholders.

• Technical risk refers to the likelihood that it will not be possible to develop asystem that will function technically. Engaging an outsourcing vendor may wellresult in a reduction of technical risk for a number of reasons. First, the outsourcingvendor may be able to retain personnel who are technically more skilled. Second,the outsourcing vendor is likely to have had more opportunity to develop technicalskill. Third, if the outsourcing vendor has a portfolio of development projects it maybe able to apply a variety of different technological solutions so that if one fails,it has at least one other technological alternative to consider. The outsourcingvendor is likely to want to be compensated for reducing the outsourcing company’stechnical risk. Technical risk cannot be completely eliminated, especially when theoutsourcing vendor is being asked to provide state-of-the-art technical solutions.

Another important risk faced by organizations that depend to a significant extent on ITis obsolescence risk. Technologies that were state-of-the-art last year are passé thisyear. The risk of obsolescence can be reduced through thoughtful gathering of competi-tive intelligence, experimentation with a variety of technologies, and partnering withorganizations at the leading edge, technologically speaking (Elitzur & Wensley, 1998).Organizations also face the risk of losing key personnel. The personnel risk derives fromlack of challenging tasks and lack of relevant compensation. The IS function is oftenconsidered to be a support function somewhat divorced from the primary value-addingprocesses of the organization. This makes it difficult for organizations to compensateindividuals with significant technical expertise sufficiently. They are also unable toprovide their technical staff with access to state-of-the-art problems or technologies.Employing an outsourcing vendor may counteract this risk by providing the IS staff ofthe outsourcing company with a superior employment environment. However, this isonly beneficial to the outsourcing company if it is able to access its former employees(Elitzur & Wensley, 1998).

Technology Upgrading

A concern that is common in many outsourcing agreements is how to structure suchagreements to ensure that the outsourcing vendor is motivated to use the mostproductive technology. The outsourcing company wants reassurance that the outsourcingvendor will upgrade its hardware, software, and personnel as and when appropriate. Afixed-price contract may provide significant incentives for the outsourcing vendor toinvest in technologies that improve its productivity. However, the benefits of anyimprovements in productivity will accrue only to the outsourcing vendor (Elitzur &Wensley, 1998).



How do we ensure that the outsourcing vendor shares some of the benefits of investingin more productive technology? Levina and Ross (2003) suggest that sharing of benefitsis part of the vendor’s value proposition. One way to ensure that this takes place is tostate explicitly in the contract an assumption about expected productivity improvementsover the lifetime of the contract. This will induce the outsourcing vendor to at least matchthe productivity improvements that have been contracted for. It may also be appropriateto agree to share the benefits of any productivity improvements over and above thosestipulated in the contract.Another action that the outsourcing vendor can take is to demonstrate that it investsheavily in keeping its personnel up-to-date, that it replaces its hardware and software ona regular basis, and that it has alliances with major software and hardware vendorsallowing it to have access to state-of-the-art technology. To the extent that theoutsourcing vendor takes these actions before signing an outsourcing contract it isengaging in signaling (Elitzur & Wensley, 1998).If the outsourcing company requires that it take some, or all, of these actions onassumption of the outsourcing contract, the outsourcing company is engaged in whatis termed screening. Screening occurs when the outsourcing company attempts todesign a contract that will be significantly more attractive to the outsourcing vendor whointends to keep up-to-date compared to the outsourcing vendor who has no interest inkeeping current. For screening to work efficiently it must be uneconomical for theoutsourcing vendor who does not intend to keep up-to-date to enter into such agree-ments (Elitzur & Wensley, 1998).Technology upgrading is an interesting example of, first, investigating how the outsourcingvendor can be induced to create added value by investing in new technology, andsecond, of determining how the surplus will be divided between the parties. These twoissues are clearly related.

Contract Duration

Generally speaking, the longer the duration of the contract the greater the danger thatthe outsourcing company will find itself “locked in.” It is interesting to note that overthe last decade the average duration of outsourcing contracts has decreased somewhat.One would expect that as the duration of an outsourcing contract increases, both partieswould negotiate terms that reduce the likelihood of either party being locked in. Theprincipal rationale for this is that the existence of such a danger may undermine anagreement that may be valuable to both parties or result in an agreement that is lessvaluable as a result of the need to provide compensation for such a risk (Elitzur &Wensley, 1998).As we have noted earlier, there are a variety of ways to which the risk of either party beinglocked in can be reduced. The development of standardized systems, the use ofcommonly available technology, and the use of generally accepted systems developmenttechniques and clauses requiring the retraining of personnel when a particular outsourcingcontract expires are just some examples. As we have noted previously in the section on



asset specificity, the transfer of IS assets from the outsourcing company to theoutsourcing vendor may also reduce the likelihood of lock-in.Another way of reducing the danger of lock-in is to provide for the possibility of contractrenegotiation at intervals during the life of the contract. Such flexibility does incur costs.Contract renegotiation is itself costly, and it may be difficult to restrict negotiations toa small subset of the terms of the contract.Finally, the danger of lock-in may be reduced through the use of relatively vague contractlanguage or flexible contract terms. Even if the contract language is not vague over thelife of an outsourcing contract extending well into the future, many unanticipatedsituations are likely to be encountered. Flexible or vague contracts require that the twoparties establish close relationships to ensure the stability and predictability of thearrangement. Thus, relationship management, the topic of the next section, is critical tothe success of long-term outsourcing arrangements (Elitzur & Wensley, 1998).

Due Diligence

The world of mergers and acquisitions (M&A) has learned the importance of conductingin-depth legal and financial due diligence, yet many acquisitions still fail to live up toexpectations. The most common reasons actually relate to flaws in the business strategyof the acquired company rather than tangible shortcomings that the accountants andlawyers can identify. Broadening the scope of due diligence has turned out to be theanswer for many private equity investors (Lislie, 2003).A structured process of evaluating the business strategy of the target company relativeto the marketplace improves the chances of any acquisition success. An in-depthinvestigation of the market, competitors, customer behavior, consumer attitudes, brand,and company positioning usually sheds light on issues that provide the acquirer withincreased confidence to move forward, uncover problems, which lead to a reduced priceor induce walking away. Is the target company positioned properly to capitalize on thekey market drivers? How do customers really make their purchase decisions? What aretheir unmet needs? What are their switching costs? What is the strategy of thecompetition? How have they chosen to differentiate themselves? The future performanceof a target company can be predicted with a higher level of accuracy by having fact-basedanswers to these questions and many others, not just anecdotal information.Lislie (2003) argues that the most successful acquirers systematically assess thequalitative aspects of their deals as the first step in the due diligence process. The corecompetency of the deal team of a private equity group typically revolves around makingthe single go/no-go decision regarding investment, based upon the individual (and oftencontradictory) analyses of the various aspects of due diligence. Suppose that legal duediligence reveals few concerns, accounting has many concerns, environmental has noconcerns, and technical says, “Invest now!” The act of making the decision to invest ornot, based on conflicting pieces of evidence is the real core competency.



Outsourcing Relationships

There is no easy answer to the question about what makes a relationship a partnership.Common suggestions that partnership is a close relationship are vague and do not offermuch help. In order to give meaning to closeness, one has to consider the degree ofintegration between the buying and the selling company. The extent of integrationbetween customer and supplier, for example, expressed in terms of the specific invest-ments made by either partner, may have an impact on the performance of the relationship(Gadde & Snehota, 2000).In terms of specific investments made by outsourcing partners, a distinction can be madebetween tangible assets (buildings, tools, equipment, and processes) and intangibles(time and effort spent on learning the business partner’s practices and routines).According to Gadde and Snehota (2000), there is significant evidence that the size ofinvestments dedicated to a specific counterpart significantly correlates with practicescommonly associated with strategic partnerships, such as long-term relationship, mutualtrust, cooperation, and wide-scope relationships.Focusing on integration is an important step toward a better understanding of the criticaldimensions of relationships. It requires consideration of the actual behavior in relation-ships, rather than relying on a notion of partnerships as a matter of vaguely definedpositive attitudes. We need to elaborate further on the extent of integration in relation-ships, and so Gadde and Snehota (2000) propose involvement as a relevant concept.Three dimensions of involvement can be distinguished that affect outcomes in relation-ships: coordination of activities, adaptations of resources, and interaction amongindividuals. The degree of involvement in the three dimensions can be referred to asactivity link, resource ties, and actor bonds.First, the activities carried out at the vendor and client companies can be more or lesstightly coordinated. Examples of tight activity coordination are integrated deliverysystems where the vendor and the remaining internal IT function coordinate their activityto provide superior user service. Second, the resources of the companies can be moreor less specifically adapted to the requirements of the counterpart. Examples arecomplementary competencies. Third, the individuals in the companies may interact moreor less intensely. Close interaction among individuals in the two organizations make theirchoices more independent and affect both commitment and trust in the relationship,which in turn impacts on coordination and adaptations. Some relationships score highon all three of the relationship dimensions, while others only on one or two.The existence of strong links, ties, and bonds describes the degree of involvement of thecompanies in a relationship. Gadde and Snehota (2000) prefer the concept of involvementrather than integration, because it makes possible a distinction between vendor involve-ment and client involvement. In this context, extensive activity links, resource ties, andactor bonds characterize high-involvement relationships.High-involvement relationships are costly because coordination, adaptation, and inter-action entail costs. Increasing involvement usually means a substantial increase inrelationship costs, but may, under certain circumstances, lead to lower direct transactioncosts. However, the main rationale for high involvement is either to achieve cost benefits



in terms of reduced costs in production, improved flexibility, and service levels, orrevenue benefits, for instance, through taking advantage of vendor skills and capabilityto improve the quality of the customer’s end product. Increased involvement only makessense when the consequently increased relationship costs are more than offset byrelationship benefits. Reaping these benefits most often requires nonstandardizedsolutions and customer-specific adaptations. High-involvement relationships are asso-ciated with investment logic.Low-involvement relationships have their rationales as well. They can be handled withlimited coordination, adaptation, and interaction costs. Generally, this is the case whenthe context is stable and the content of the relationship can be standardized. In thesesituations the requirements of the customer can be satisfied by use of existing solutions.This means that no specific product or service adaptations are needed, implying thatresource ties are minimized. When activity coordination can be limited to standardizedservices, such as outsourced communication and network operations, the activity linksare weak. Finally, when interaction among individuals in the two companies involved canbe contained to sales and purchasing administration, the actor bonds will also be limited.

Relationship Management

It is often a requirement in outsourcing contracts that a relatively intimate relationshipbe established between the outsourcing company and the outsourcing vendor. Theexistence of such a relationship may reduce the need for detailed monitoring of theperformance of the outsourcing vendor by the outsourcing company. Ongoing relation-ships may lead to the establishment of trust and perceptions of common interest. Themore the outsourcing vendor interacts with the outsourcing company the more comfort-able they are likely to feel with each other (Elitzur & Wensley, 1998).Close relationships are likely to be enduring if they arise from genuine common interests.It is important to ensure that these common interests are established in the structure ofthe outsourcing arrangement and nurtured throughout the duration of the contract. Inorder to facilitate the establishment of common interests and understanding, it is oftenargued that outsourcing companies should seek out outsourcing vendors with similarvalues and cultures. However, an outsourcing company should be careful not to put toomuch faith in the effectiveness of close relationships in causing the outsourcing vendorto act in the best interest of the outsourcing company. The interests of the outsourcingcompany must find a way of designing a set of incentives that ensure that it is in theinterest of the outsourcing vendor to act in the interest of the outsourcing company.Close relationships allow each party to make inferences about the beliefs, perceptions,and possible actions of the other party with more confidence than in situations whererelationships are not close. Further, the trust that may arise in such relationships maylessen the perceived likelihood of demands for renegotiation.An interesting combination of cooperation and conflict arises in many outsourcingrelationships. Cooperation arises with respect to establishing arrangements that create



value that would not have existed otherwise. Conflict arises with respect to dividing upthe resulting surplus value. The management of such hybrid relationships is difficult(Elitzur & Wensley, 1998).

Fee Arrangements

One of the key elements of an outsourcing contract relates to how fees are structured andadjudicated. Based on Elizur and Wensley (1998), we will first consider how fees aretypically calculated and then examine the implications of a variety of different feestructures for both parties in an outsourcing arrangement.How are fees calculated? In cases where performance is easy to measure, fees may berelatively easy to determine. For example, in the case of facilities management, CPUminutes, disk access times, tape mounts, and so forth, may be relatively easy to verify.Even here, however, there may be problems since there may be a concern that theoutsourcing vendor is not using the technology efficiently or not using state-of-the-arttechnology. For example, the outsourcing vendor may be using mainframe software andhardware when client/server network technology would be more efficient. Conversely,the outsourcing vendor may significantly upgrade its hardware/software but not passon any of the savings resulting from improved productivity to the outsourcing company.Problems of measurement are compounded when the outsourcing vendor has beencontracted to provide IS that are strategic. In these cases, performance measures mayhave to be related to the business value of such systems rather than their technicalperformance. One interesting set of issues with respect to the fees paid under outsourcingarrangements concerns whether fees are fixed or variable or some combination of fixedand variable. Let us examine these issues in a little more detail.Minimum or maximum fees? Minimum fees would seem to be of benefit to the outsourcingvendor since they guarantee that it receives a minimum level of payment regardless ofdemand from the outsourcing company. Why would the outsourcing company beprepared to offer such a guarantee? One answer relates to the magnitude of the specificassets that the outsourcing vendor has to acquire to provide the outsourcing companywith information services. The outsourcing vendor expects to earn a reasonable returnon these assets—a minimum fee can guarantee a minimum acceptable return. Theexistence of this minimum level of return may guarantee that it is possible to reach anagreement and/or reduce any risk premium paid to the outsourcing vendor to compensatefor the risk of being locked in.Establishing a maximum fee is of potential value to the outsourcing company since itestablishes an upper limit on the potential costs associated with its acquisition ofinformation services. Simultaneously with a maximum fee being a potential benefit to theoutsourcing company it has the potential of requiring the outsourcing vendor to provideinformation services at a loss.The relative risk of maximum and minimum fee arrangements to either party to anoutsourcing agreement depends on future demand patterns. Each party in the outsourcingagreement is in a different position with respect to their ability to forecast these demand



patterns. It would seem that the outsourcing company is in a superior position withrespect to forecasting the future level of business demand patterns. In contrast theoutsourcing vendor is in a superior position with respect to being able to forecast howbusiness demands are translated into technical demand requirements.How are fee adjustments handled? Many outsourcing agreements provide for themodification of fees/payments made under the agreement in certain circumstances.Adjustment mechanisms mitigate the risks of being locked-in if unanticipated eventsoccur. Some mechanisms bring with them both explicit costs (renegotiation costs) andimplicit costs (some gains may be given up on renegotiation if the balance of power haschanged).Establishing fixed fees for certain information services is common practice in the industryand often relates to one-off project-based services rather than transaction-basedservices. For example, in systems development it is quite common for the outsourcingcompany to set fixed fees for specific projects. In cases where it may be difficult toforecast demand and/or the costs faced by the outsourcing vendor do not have a verysignificant fixed component, straight usage fees for services may be negotiated.An outsourcing vendor may be provided with additional incentives in the contractthrough being able to guarantee shared savings from reduced head count, increasedthroughput, and reduced error. Shared revenues have a stimulus similar to the cost-savings approach except that it recognizes that systems should be developed ideallyboth to reduce the costs of business for the outsourcing company and increase revenues.Bottom line approaches are fees based on realizable net profit from the implementationof new IS and services. Finally, combination approaches are often found in outsourcingcontracts. This allows for a tailoring of fee structures to match the information the partiesare prepared to disclose to each other and the degree of exposure they are prepared toentertain (Elitzur & Wensley, 1998).

Dispute Resolution

Inevitably, disputes will arise during the life of the contract. Dispute resolution proce-dures are often provided for in some detail in the outsourcing contract. With all theseprocedures it is important to bear in mind that it may not always be appropriate to followthem, and provisions should be specified acknowledging those circumstances. Theseinclude where one party simply refuses to participate in the process, where one party hascommitted a material breach of the contract, or where a party suspects that its intellectualproperty rights are, or are about to be, infringed or believes that its confidentialinformation is, or is about to be, disclosed other than in accordance with the terms of thecontract (in which case immediate action, such as obtaining an injunction, will be requiredto protect the rights of that party) (Lewis & Welterveden, 2003).The first formalized mechanism of dispute resolution usually involves an escalationprocedure between various representatives of the parties. For example, the contractmanagers may first attempt to resolve any disputes and, if they are unable to do so, thematter is then referred to the respective finance directors of the parties and ultimately,



to the chief executive or managing director level. The intention behind these escalationprocedures is to encourage resolution of more minor matters at a low level within theorganizations. It will not look good for either party if a dispute about a particular chargeunder an invoice or the quality of a particular set of reports delivered by the supplier isreferred to the chief executives/managing directors for resolution.The result of the internal escalation process means that it delays the point at which eitherparty can seek adjudication outside the contract by referring the matter to the courts oran alternative form of dispute resolution (such as mediation or the use of an expert). Itwill not always be to the best advantage of the customer to be compelled to follow aninternal escalation process, which may take some months to follow, before being free topursue legal action in the courts, particularly as it will usually be an alleged default ofthe supplier to which the dispute relates. As the obligations of the customer under thecontract are invariably limited (with payment being the most key requirement), thepotential for the dispute to relate to the customer’s performance is restricted. The threatof court action, with its attendant negative publicity and high costs, can often encouragean early settlement by the supplier. However, most customers are willing to take the viewthat they should look to resolve disputes by working together with the supplier ratherthan automatically taking court action and for this reason: escalation mechanisms arecommonplace in most technology outsourcing contracts.In the event that the parties cannot resolve the dispute through the internal escalationprocedure, then typically the parties would refer the matter to the courts. It is well knownthat the costs of such court action can be extremely high and that court action is verytime consuming. A further problem is that disputes can often be of a highly technicalnature, so judges may lack the detailed knowledge and expertise to be able to fullyunderstand the issues in question. For these reasons, the parties may therefore look tobuilding into the contract alternative forms of dispute resolution. This also reflects theneed to look at appropriate forms of alternative dispute resolution. Litigants will be askedwhether they considered or actually participated in other dispute resolution mechanismsbefore resorting to the courts. For those who have not, there can be significant costsimplications (Lewis & Welterveden, 2003).Such other forms of dispute resolution process may involve the referral of disputes ofa technical nature to a third-party expert and other disputes to mediation (Lewis &Welterveden, 2003). Where an expert is to be used, then the contract may leave it for theparties to determine the identity of the expert to be used. Any failures to agree may requirean independent third party to intervene to appoint a suitable expert. The parties will needto provide the expert with all relevant information. Time periods should also be specifiedfor the expert to consider the representations of the parties and to provide a judgment.The expert will usually be asked to determine at the time of giving judgment who shouldbear the costs of the proceedings, taking into account the conduct of the parties and theoutcome of the proceedings.In relation to the use of mediation to resolve other disputes, again the contract shouldspecify a body that, in the event of a failure by the parties to agree on the identity of amediator, will be required to appoint one. The use of any such form of alternative disputeresolution process should be based on the mutual consent of the parties.Finally, arbitration can also be used. Arbitration is a form of binding dispute resolution.An arbitrator is appointed and proceedings are conducted in confidence. Decisions



cannot be appealed, unless it can be shown that the arbitrator acted in bad faith or unlessit can be established that the arbitrator’s decision was wrong in law. Arbitration is mostlikely to be appropriate where the parties to the technology outsourcing contract comefrom a number of jurisdictions and arbitration can therefore provide a more neutral forumfor dispute resolution (Lewis & Welterveden, 2003).

Public Sector

Consideration of public-sector outsourcing requires an understanding of the uniquefactors and legal and regulatory frameworks that affect government and that do notnecessarily apply to private-sector outsourcing. Although there are many similarities inthe way in which the private and public sector approach outsourcing, there are a numberof key differences such as (Hughes, 2003):

• the existence of a legislative procurement regime for the award of contracts;• statutory provisions that govern what types of services can be contracted out as

well as statutory provisions that can affect the terms of an outsourcing transaction;• the need to meet objectives set by a wide range of stakeholders such as politicians,

members of the public, and government staff and unions;• a difficulty in defining the business benefits arising from outsourcing because they

are not always financially driven; and• the impact the political dimension can have on an outsourcing transaction.

At the heart of public procurement law is the concept of competitive tendering. In Europe,tendering exercises are governed by the European Union procurement regulations, buteven where these principles do not apply, most contracting authorities have internalrules that require a competition of some sort as a means of demonstrating fairness,accountability, and value for money. These rules and procedures for competitivetendering are normally found in the contract standing orders of a public-sector body(Hughes, 2003).

Conclusions

Contracts were often neglected in the first wave of IT outsourcing. The talk of strategicpartnership was dominant. From experience, we have learned that a good contract isneeded when daily life runs into problems. A good contract structure with detailed assettransfer descriptions, risk-sharing definitions, technology-upgrading options, contractduration, relationship management, fee arrangements, and dispute-resolution proce-dures is needed to manage IT outsourcing relationships successfully.



Case Studies: ContractDevelopment and Management

In the original outsourcing agreement between Rolls-Royce and EDS, assets wheretransferred and services bought back through two different contracts: one for theaerobusiness and one for the industrial business. In 2000, these two contracts weremerged into one contract. All of the time that Rolls-Royce had been in the arrangement,services had been taken away and new services were added. The result was that theoutsourcing contract had been more complicated. In the beginning, the two contractswere arrangements around capability and scale. What they were doing in 2000 was toorganize the new contract around services that could be provided. The new structure wasan overall master services contract, and then pieces to be managed called towers, forexample, data centers, networks, and application support. Having had a period wherethey spent much time arguing around interpretations of contractual clauses, Rolls-Royceand EDS reached the point where they hardly used the contract in the day-to-dayoperations. The two parties understood each other’s goals. If there were changesrequired to the contract, then they instructed the lawyers to do them. Rolls-Royce hadan IT procurement team, a dozen people who were part of the central procurement unitbut had a functional accountability to the IT community. These people did follow-up thecommercial part of the contract.Concurrent to asking for binding bid, SAS sent contractual suggestions to potentialvendors, and it asked for remarks to this suggested contractual conditions. Thepreviously contractual relationship between SAS and SIG served as a base for the newoutsourcing contracts. Reviewing both binding bids and contractual comments was alearning process for both client and vendor, as they learned more about each other andthe services to be delivered. All information around systems solutions, for example,source code, costs, and service levels, was accessible for bidders in certain “data rooms.”SAS was well prepared in the contractual negotiations and it used internal and externalexpertise such as lawyers, purchasers, and financial experts. The contract was structuredin four parts. First there was an overall Master Service Agreement, which laid out thelength of relationship, minimum level of services for the 5-year agreement, and optionsfor extending the agreement. Then there was a Share Purchase Agreement, which wasregulating the sale of shares, price of shares, balance sheet, bonds, pensions, and soforth. And then there was a Transition Agreement describing activities tied to the transferof assets, for example, transferring of IT employees, facilities, hardware, and softwarelicenses. This agreement was to last for six months, and then all major transition activitieswere finished. And last, there was a Frame Agreement, which laid out terms andconditions for the buyback of services. This agreement was a traditional serviceagreement deal with service description, service levels, prices, conditions, templates,and so on. The deal was a 5-year contract, starting February 1, 2004, with options forextention. CSC must make an effort to get SAS to provoke the option. On the other hand,SAS had the freedom to evaluate the quality of services delivered and to pick a newsupplier without being locked for a too-long a period of time. There had been somecontractual interpretation issues, especially concerning price and service clauses. Butthese issues had been handled successfully by the relationship steering committee,



where both parties were represented. Each business unit in SAS was responsible for itsown use of IT services and its own costs, and thus it had business relationship with CSC.Contract managers on the CIO’s staff did contractual follow-up at corporate level.

Both parties had accepted the agreement, but we also tried to get the maximum out ofsituations where contractual clauses opened up for interpretations. -Vendor AccountManager

At ABB core contract documents were negotiated globally, because a service providercan only leverage economies of scale if there were some similarities in the environment.The global teams also negotiated one basic country contract, which were used in the localnegotiations, for example, between ABB Norway and IBM Norway. Statement of workwas negotiated globally. Country adjustments contained local supplements andcreusements. It was some kind of customer adjustment. Responsibility for countryagreements were distributed but supported with expertise from the global teams. Eachcontract had several exhibits and schedules. Exhibits included, for example, form ofcountry agreement, country agreement, and country adjustment. Then there were severalschedules, for example, acquired assets, employees, facilities, software, transition,service recipients, charges, governance, security, business continuity, exit management,subcontractors, and service measurements. The two parties were trying to verify as muchas possible, and “nothing” should be left to coincidence. It was a very complexcontractual set up, with one global agreement and 14 separate country agreementsoperating under it, and there were some very complex linkages. It was really a globalagreement, meaning that the country agreements did not operate independently. If IBM,for example, defaulted in one country, subsequently ABB had the right to terminate inthat country, and then it had the right to terminate in all countries participating in theagreement.The basic assumption within contractual theory is that every contract has the purposeof facilitating exchange and preventing opportunism. Lou (2002) argues that contract andcooperation are two central issues in an IT outsourcing arrangement. The ABB–IBMoutsourcing relationship was based on a complex contractual set up, with both globaland local agreements, and complex linkages between them. The outsourcing contractprovided a legally bound, institutional framework in which the two party’s rights, duties,and responsibilities were codified and where the goals, policies, and strategies under-lying the arrangement were specified. Although they had tried to cover “everything,”contractual completeness is Utopia. For example, in Norway there had been severalcontractual changes or supplements within the first year of the deal. Because ofenvironmental dynamism, contract and contract governance also had to be dynamic.ABB and IBM had recognized the need to manage the relationship professionally, anda relationship alignment project was the enabler for supporting the contractual andcommercial relationship between the two parties.SAS and CSC had a professional attitude toward developing the Master ServiceAgreement, Share Purchase Agreement, Transition Agreement, and Frame Agreement.Negotiating the contract, a skilled team from SAS met a special European businessdevelopment team from CSC. The contract was more complex and comprehensive than



any previous deal between SAS and SIG. In spite of this, the steering committee of therelationship had several times been forced to handle disagreements regarding interpre-tation of contractual terms. The committee had yet to resolve all interpretation issues.As Lou (2002) argue, a contract alone is insufficient to guide outsourcing arrangement;cooperation is also needed.



Chapter VIII

Personnel Issues

Many of the potential problems with outsourcing can be avoided by carefully decidingwhich IT services can appropriately be contracted out and which cannot. Other problems,however, can only be avoided by an effective implementation of that decision and onesuch is the potential staff problem when transferring IT management and operation toan external body.Staff, however, often find the growth potential, greater variety, and greater businessfocus of some outsourcing jobs very appealing, and working for an outsourcing vendoris actually popular with some staff once the transition has been made. To an IT staffperson, the vendor organization can offer wide and interesting career paths and almosta return to the traditionally sized IT section with all its scope for specialism. This varietyof career path is unlikely to be offered by the slimmed-down IT provision internal to mostorganizations. The vendor’s core business is IT and hence resources flow into newdevelopments and advances in a way that can give interesting and rewarding careeropportunities. Instead of IT staff being treated as a necessary overhead, they becomethe organization’s critical asset. Not all outsourcing jobs are equally appealing, however,and some roles can be very unpopular (Robson, 1997).

Reduction in IT Staff

Lacity and Willcocks (2000b) found that 63% of U.S. and U.K. companies reduced ITheadcount as a consequence of IT outsourcing. They asked respondents whetheroutsourcing led to reduced IT staff, and if yes, what percentage among several methodsof staff reduction tactics was used. Methods of reducing staff included transfer tosupplier (32%), redundancy in terms of attrition and termination (31%), replace in-house

Personnel Issues 185


staff with supplier staff (20%), and internal staff transfer (17%). Given that typically ITsalaries are the largest portion of IT budgets, one would expect that staff reductions arerequired to realize expected cost savings. Most respondents in the survey reported noproblems with transferring staff to the supplier. Thirty percent, however, reporteddifficulties. In these cases, some of the employees did not want to go. Some foundpension rights not equal, some did not want to change locations. In these cases,outsourcing can be generally bad for morale. It hurts because current systems are toopeople specific because there is a lack of in-house documentation.Barthélemy (2003b) reports that a European department store had to close down for twodays because its 70 facilities management personnel went on strike. The shutdown tookplace during an important sales promotion and resulted in the loss of several millioneuros. This strike was partly due to constant rumors that facilities management wouldbe outsourced. These rumors were essentially fueled by the fact that retiring facilitiesmanagement employees were never replaced. Basically, their colleagues were afraid ofbeing transferred to the vendor (with lower pay and benefits) or being laid off. Outsourcinghas a negative impact on employees’ sense of job security and loyalty. Barthélemy(2003b) defined overlooking personnel issues as the fourth deadly sin of outsourcing.It may seem surprising that firms can gain something from outsourcing if they merelytransfer their employees to a third party and ask that it maintains the same pay andbenefits. However, there is more to outsourcing than transferring people and renegoti-ating their pay and benefits. Multiple clients enable specialized vendors to operate at ascale unattainable by their individual clients. Because of the variety of their clients,specialized vendors also have a depth and range of experience that an individual clientcannot match.

Employment Protection

There are a number of legal employment issues involved in outsourcing. For example, animportant aspect of European Union social policy has been how to help the process ofchange that has occurred, and will continue to occur, in all member states as a result ofthe development of the single market. The result of this change is increased levels ofmergers and acquisitions, insolvencies, and redundancies. This has given rise to anumber of measures designed to provide some protection for the workers involved inchange processes in order to make such processes more acceptable. Two such protectionmeasures that have a direct effect on the process of outsourcing are the Acquired RightsDirective and the Collective Redundancies Directive. In the United Kingdom, theAcquired Rights Directive is transposed into national law by the Transfer of Undertak-ings Protection of Employment Regulations, while the Collective Redundancies Direc-tive is transposed into national law by the Trade Union and Labour Relations Act(Sargeant & Vassell, 2003). Both transfer regulations and Labour Relations Act have beenthe source of litigation in outsourcing. For example, the effect of transfer regulations isto transfer an employee’s contract of employment from the transferor employer to thetransferee employer. The main legal question here is in what circumstances the transfer



of a function from an in-house operation to a third-party service provider (a first-generation transfer) or a subsequent change of service provider, as a result of retendering(a second-generation transfer), will constitute a relevant transfer of an undertaking. Ina case decision at the European Court of Justice, the law applies as soon as change occursof the natural or legal person operating the undertaking, who in that capacity, hasobligations vis-à-vis the employees in the undertaking, and that it is of no importancewhether the ownership of the undertaking has been transferred.The main legal question here is in what circumstances the transfer of a function from anin-house operation to a third party service provider (a first-generation transfer) or asubsequent change of service provider, as a result of retendering (a second-generationtransfer) will constitute a relevant transfer of an undertaking. In a case decision at theEuropean Court of Justice, the law applies as soon as change occurs of the natural or legalperson operating the undertaking who, in that capacity, has obligations vis-à-vis theemployees in the undertaking, and that it is of no importance whether the ownership ofthe undertaking has been transferred.The test, therefore, is whether there has been a change in the natural or legal personrunning the operation, as would normally take place in an outsourcing situation. If theoperation that is transferred is an identifiable entity before and after the transfer, thena relevant transfer is likely to have taken place. The Court of Justice then gives furtherguidance as to factors that would help in the decision as to whether a transfer has takenplace. It is necessary to take all the factual circumstances of the transaction into account,including (Sargeant & Vassell, 2003):

• the type of undertaking or business in question;• the transfer or otherwise of tangible assets such as hardware and software;• the value of intangible assets at the date of transfer;• the majority of staff are taken over by the new employer or not;• the transfer or otherwise of customers;• the degree of similarity between activities before and after the transfer; and• the duration of any interruption in those activities.

The Court stated that each of these factors is only part of the assessment. One has toexamine what existed before the transfer and then examine the entity after the change inorder to decide whether the operation is continued (Sargeant & Vassell, 2003).

Pension Considerations

Most outsourcing transactions will involve a transfer of employees from one entity toanother. The employment law implications of such a transfer have been considered in theprevious section. Although related to the general employment law position, the structure



of occupational pension schemes, their unsettled relationship with the contract ofemployment, and the exemption applicable to occupational pensions mean that theyrequire separate consideration (Catchpole, 2003).Most employees of medium to large employers will have access to a pension scheme aspart of the benefits package offered by such employers to their employees. The type ofpension arrangement in which the outsourced employee participates will affect howpensions are dealt with in the outsourcing process. Broadly, relevant European Unionlaws provide that where an employee transfers to another employer as part of anundertaking, the terms and conditions of employment also transfer. As a result, thetransferee employer has an obligation to provide at least the same terms and conditionsfollowing the transfer.There can be quite a difference in the quality of documentation provided by or in respectof occupational pension schemes. Most self-administered occupational pension schemeswill have a reasonably full set of documentation. The difficulties tend to arise withinsurance company-based products. Quite often the only document that might beavailable is a copy of the proposal form or a spreadsheet of how much the employer payseach month. As a result, it is not always easy to identify the nature of the pension schemeand, consequently, the pension promise. In these circumstances, the transferee (the newemployer) will need to place greater reliance on the strength of its warranty protection.The transferee will normally agree to pay the contributions due, usually at a rate specifiedin the agreement.For the transferor (the old employer), the most important point to be negotiated is thecalculation of the transfer amount. How this amount will be calculated will be a matter ofnegotiation between the parties, subject to employees’ statutory entitlements to aminimum of the cash equivalent of their accrued benefits. It may be agreed that thetransfer amount is to be calculated using one of the following methods: as a share of theoverall fund, on a past-service reserve basis, or as the transferring employee’s statutoryequivalents (Catchpole, 2003).

Predictors of PersistentStakeholder Expectations

Theoretically, IT outsourcing research has a basis in economic theories, organizationaltheories, and strategic management theories. Below, alternative theories from the fieldof social and cognitive psychology will be used to extend and strengthen the theoreticalunderstanding of this complex field.

Perception as Subjective Understanding

Human nature is implicit in the idea of cognition. And historically, cognitive psycholo-gists have studied perception, memory, attention, pattern recognition, problem solving,



sensemaking, and a host of other problems. According to Neisser (1976), perception iswhere cognition meets reality. And thus, perception is surely a matter of discovering(through reading, listening, feeling, looking) what the environment is really like andadapting it.Neisser introduces the perceptual cycle as a constructive process, where the anticipa-tory schemata direct explorations, and the outcome of the explorations (the informationpicked up, called perceptible objects) modifies the original schema. As people developdifferent anticipations, they pick up different information. Every person’s possibilitiesfor perceiving and acting are entirely unique, because no one else occupies exactly hisor her position in the world or has had exactly his or her history (Neisser, 1976). InNeisser’s terminology a schema is that portion of the entire perceptual cycle which isinternal to the perceiver, modifiable by experience, and somehow specific to what is beingperceived. In normal environment, most perceptible objects and events are meaningful.They afford various possibilities for actions, carry implications about what has happenedor what will happen, belong coherently to a larger context, possess as identity thattranscends their simple physical properties.In the psychology of perception, a distinction is made between “stimulus” and “stimulusobject” (Kerch, Crutchfield, & Livson, 1974). A stimulus object is the source of thestimulus, while a stimulus can be seen as the data associated with the stimulus objectnoticed and interpreted. Potential problematic situations vary in degree of tension, wheredegree of tension reflects whether signals are strong or weak with respect to the existenceof a problem. To be noticed, signals must be available to the observer, and of minimumstrength to exceed certain thresholds in human perception. To what extent informationis perceived as relevant cannot, however, be viewed as detached from the problem owner,as perceived relevance is a function of the situation and the perceiver.Differences in core assumptions regarding the nature or “reality” of problems (as forother phenomena) can be classified along the dimension “objective-subjective” (Mor-gan & Smircich, 1980). The extreme objectivist conception of problems reflects the viewthat reality is a concrete structure in which problems represent objective entities with anexistence independent of the observer. The environment is seen as teeming withproblems that thrust themselves upon us. According to the extreme subjectivist concep-tion of problems, in contrast, problems are not objects in the world to be discovered, butlabels we assign to given situations. Problems are viewed as mentally projected catego-ries of events or situations, which cannot be seen isolated from a problem owner.In an eclectic review of major contributions addressing managerial problem finding, Laiand Grønhaug (1994) find competing vocabularies and perspectives; problem finding,problem sensing, problem identification, problem recognition, problem discovery, prob-lem assertion, problem formation, and problem construction. In their research, the relativeinfluence of environmental and psychological determinants of problem finding areinvestigated. The boundaries between evident, implicit, and potential problems are,however, fuzzy. And they conclude that the more complex, the more important theindividual subjective understanding (Lai & Grønhaug, 1994).As we have seen, a common pattern among different authors studying cognition is theiremphasis of individual subjective understanding. IT outsourcing is not only aboutconcrete technical structures, but it is also about organizational, individual, and rela-



tional changes. Individuals discover environmental changes, based on their individualposition and history. Thus, it is reasonable to propose that individuals perceive thecomplex IT outsourcing situation differently. The emphasis of individual subjectiveunderstanding will be followed in this study, as the unit of analysis is at the individuallevel.

Sensemaking

The concept of sensemaking is well named because, literally, it means the making of sense(Weick, 1995). Weick argues that sensemaking is about such things as placement of itemsinto frameworks, comprehending, redressing surprise, constructing meaning, interactingin pursuit of mutual understanding, and pattering. Sensemaking is not an explanatoryprocess such as understanding, interpretation, and attribution. It is understood as aprocess with at least seven distinguishing characteristics: grounded in identity con-struction, retrospective, enactive of sensible environments, social, ongoing, focused onand by extracted cues, and driven by plausibility rather than accuracy. Althoughindividuals do sensemaking processes, it holds true for organizations as well.To organize is to impose order, counteract deviations, simplify, and connect, and thesame holds true when people try to make sense. Although content is a key resource forsensemaking, of even more importance is the meaning of this content. And that meaningdepends on which content gets joined with which content, by what connection. Contentis embedded in cues, frames, and connections, and these are the raw materials forsensemaking (Weick, 1995).Processes of sensemaking are either belief driven or action driven, as shown in Figure8.1. Following Weick (1995), believing is seeing, and to believe is to notice selectively.And further, to believe is to initiate actions capable of lending substance to the belief.But sensemaking may also start with action, through a focus on what people do ratherthan on what people believe. There are four ways in which people impose frames onongoing flows and link frames with cues in the interest of meaning. Starting with beliefs,sensemaking takes the form of arguing and expecting. Or starting with actions, sensemakingtakes the form of committing or manipulating. Sensemaking is an effort to tie beliefs oractions more closely together as when arguments lead to consensus on action, clarifiedexpectations pave the way for confirming actions, committed actions uncover acceptablejustifications for their occurrence, or bold actions simplify the world and make it clearer

Figure 8.1. Sensemaking (Weick, 1995)

sensemaking

action-driven belief-driven

arguing expecting committing manipulating



what is going on and what it means (Weick, 1995). Thus, sensemaking involves takingwhat is clearer and linking it with that which is less clear.When arguing is dominant, weak definitions of the situation, embedded in tentative initialproposals, gradually become elaborated and strengthened as proposers confront critics.This “natural dialectic” produces either a synthesis or a winner. But beliefs can also bea key resource when they are embedded in expectations that guide interpretations andaffect target events (Weick, 1995). According to Weick, expectations tend to be held morestrongly, they are more directive, and they tend to filter input more severely, comparedto arguments. Furthermore, Weick argue that people tend to be more interested inconfirming than in rebutting or contradicting expectations. Sensemaking is as muchabout plausibility and coherence as it is about accuracy, which is why the heavy handof expectations can be a blessing as well as a curse.Also noteworthy is an observation that all input is compared with expectations. Thus,expected events are processed quickly, and which leaves time for adaptive action andalso frees attention for controlled processing. But as expectations do filter inputs, we mayalso expect that they can be a source of inaccuracy. One crucial thing about expectationsis that they can be self-correcting. When events seem to diverge from what is expected,both the expectations and the events themselves can be adjusted. The possibility of jointadjustment is what Merton calls self-fulfilling prophecies (Weick, 1995).Processes of sensemaking can explain how and why individuals and organizationsunderstand their environment as they do. When people try to make sense of IToutsourcing, it is individual (or organizational) cues, frames, and connections that givemeaning to the content. One interesting point to follow in the context of this research isthe influence of individual-level expectations. As IT outsourcing affects many peopleand in more than one organization, people’s interests in confirming their expectationsmight lead to problems if expectations are very different.

Cognitive Style

Several researchers have explored the differences between automatic and consciouscognitive modes. Cacioppo and Petty’s (1982; 1984) research on individual differencespropose that there are stable individual differences in people’s tendency to engage inand enjoy effortful cognitive activity. This single factor is called need for cognition.Individuals high in need for cognition naturally tend to seek, acquire, think about, andreflect back on information to make sense of stimuli, relationships, and events in theirworld. In contrast, individuals low in need for cognition are characterized as more likelyto rely on others, cognitive heuristics, or social comparison processes to providemeaning, adopt positions, and solve problems.Much of the research on need for cognition bears on the hypotheses that individuals whodiffer in terms of their need for cognition also differ in terms of their tendency to seekdetailed information about their world, engage in effortful cognitive activity, and enjoymore or are less stressed by cognitively effortful problems, life circumstances, or tasks(Cacioppo, Petty, Feinstein, & Jarvis, 1996). Individuals high in need for cognition



perform conscious-mode processing of information, whereas individuals low in need forcognition perform automatic-mode processing of information.Louis and Sutton (1991) introduced the phrase, “switching cognitive gears.” It is usedto call attention to the fact that cognitive functioning involves the capacity to shiftbetween cognitive modes, from automatic to conscious engagement and back again. Incontrast, need for cognition represents a (stable) personality variable reflecting indi-vidual differences in inclination to engage in and enjoy effortful cognitive activity(Cacioppo et al., 1996).Dosi (1982) introduces the concept of technological paradigms and trajectories, and statethat these can account for the often-observable phenomenon of cumulativeness oftechnical advances within an established trajectory. Within one technological path,technical change might be rigorously defined, but it might prove impossible to compareex ante two different technological paradigms and even ex post there might be overwhelm-ing difficulties in doing it on solely technological grounds. Dosi argues that individualslow in need for cognition will have no problem recognizing technical trajectories, becausethey will compare the changes within the existing structures and their own cognitiveheuristics. When faced with paradigm shifts, this comparison may lead to failure.Continuing this line of reasoning, Dosi argues that individuals high in need for cognition,with conscious cognitive processes, will be able to recognize the difference of trajecto-ries and paradigm shifts, because they are conceptualized as likely to have more positiveattitude toward technologies that require or involve effortful thinking or reasoning.Stable individual differences (high and low in need for cognition) may explain whyindividuals recognize technological paradigms and trajectories as they do. Thus, it isreasonable to propose that individuals with different needs for cognition might perceive,judge, and act differently when affected by IT outsourcing.

Belief Perseverance

Prior beliefs persevere in the face of challenges to data that created those beliefs and evenin the face of new data that contradict those beliefs. Many cognitive and motivationalprocesses play roles in belief perseverance. For instance, different people have differentreward structures that force different public stances. Politicians know that they get morevotes by promising no new taxes than by embarking on expensive programs that havenot only long-term payoffs. Such public image management is of little interest here,although it surely accounts for much real-world perseverance. More interesting ques-tions concern factors that influence private beliefs after challenges to those beliefs.Several lines of research provide insight into such belief perseverance phenomena(Anderson & Kellam, 1992).Research has dealt with three different types of beliefs: self-perceptions, social percep-tions, and social theories. This research reveals the importance of causal reasoning inperseverance. It shows that when causal reasoning is reduced, so is perseverance. Whencausal reasoning is enhanced, perseverance is increased. Forcing alternative causalreasoning reduces perseverance. The underlying mechanism appears to be the availabil-ity of causal arguments (Anderson & Kellam, 1992). Numerous studies demonstrate that



prior beliefs can bias people’s judgments of new data, particularly when the new data areambiguous. Biased assimilation occurs under many circumstances.Beliefs can be general or specific judgments. Some researchers have distinguishedbetween impression judgments based on memory for specific behaviors versus recall ofimpressions formed online as the behaviors were observed. Other researchers distin-guished between the automatic and the controlled aspects of stereotypes and prejudice.Finally, some distinguished between the hypothesis-testing aspects of a prior belief andthe confirmed beliefs resulting from biased testing of the hypotheses. Several researchteams have focused on people’s ability to discount subsets of initial information, findinga variety of influential conditions. For instance, to-be-discounted information that hasbeen integrated with to-be-used information is particularly difficult to discount. Thesevarious findings are quite different in their specifics, but they all illustrate the importanceof seemingly trivial differences in judgmental context.Anderson and Kellam (1992) suggest an additional distinction between two types ofjudgments that people frequently make. Specific judgments about a particular group orperson are typically based on fairly automatic heuristics; the availability of causaltheories will play a major role in such judgments. General judgments about a social theoryare typically based on a more controlled judgment process that includes a search forrelevant data (if there is ample time). Thus, accurate predictions about when persever-ance will or will not occur might depend not only on the type of causal reasoning inducedprior to the judgment task but on the particular type of judgment as well. Specificjudgments will be responsive to new data or challenges to old data only if such challengesincrease the availability of alternative causal theories or scenarios. The reason is that inmaking specific judgments we are typically unaware that we are using implicit socialtheories. More general judgments are fairly explicit statements of our social theories. Assuch, they need to match relevant information and thus will tend to be more responsiveto contradictory data.Anderson and Kellam (1992) conducted an experiment where they found that people’sgeneral beliefs were influenced by new data but not by explanations. Furthermore, theyfound that specific predictions about a group of risk-preferring and a group of conser-vative people were influenced by explanation but not by new data. The importance ofsocial theories in the perseverance of initial beliefs has been demonstrated in a varietyof studies. One line of work shows that one route to perseverance is through the biasedassimilation of new evidence. Anderson and Kellam tested the limits of this assimilationprocess, assessed the simultaneous effects of prior beliefs and new conclusive data, anddid so on several types of final beliefs. Their explanation manipulations replicated earlierresearch findings: Explaining a hypothetical relation between two variables can system-atically alter one’s beliefs about that relation.Anderson and Kellam (1992) found limits of biased assimilation. The most obvious were(1) that explanation-induced theories are too weak, too uninvolving, or too unemotionalto produce systematic biases in evaluation of new data (2) that the covariaton detectionparadigm is not sensitive to biased assimilation processes, and (3) that clear data are notsusceptible to biased assimilation processes. Tests of the relative strengths of causalexplanations versus new data produced the most interesting results. Subjects success-fully avoided use of explanation-induced theories when asked to give their generalopinions. They relied heavily on the data. However, when subjects made more specific



judgments, they apparently fell back on more automatic heuristic processes involvingthe availability of causal explanations. In essence, their stated general opinions did notautomatically translate into more specific working judgments.Naive theories are an interesting area for belief persistence. Naive theories allow peopleto explain events that have already occurred. More importantly, they predict possiblefutures. A fascinating feature of naive theories is their ability to survive empiricaldisconfirmation. Incorrect naive theories, such as racial stereotype explanations ofachievement-test score differences, would be relatively harmless if those theories wereeasily changed. Similarly, incorrect theories about how HIV and AIDS are (and are not)spread would be a minor social issue if direct public persuasion campaigns were effective.The long history of racial prejudice and the short history of HIV and AIDS ignorance bothattest to the perseverant nature of naive theories (Anderson & Lindsay, 1998).Anderson and Lindsay (1998) believe there are several processes contributing to theoryperseverance. Some are behavioral, some are purely cognitive, and some have theirorigins in motivation. In all cases, however, they believe that ultimately there is acognitive mechanism involving causal thinking at work. Perseverance-producing pro-cesses can be classified into three broad categories. One set involves perceptual andmemory processes that lead social perceivers to see stronger support for their naivetheories than is actually present in the relevant social data. These are the illusorycorrelation processes. The second set involves processes that in some way change thedata that are brought to bear on evaluation of a person’s naive theory. These are referredto as data distortion processes. The third and final set involves heuristic judgmentprocesses that tend to bolster a priori naive theories. These are the available elementsprocesses. These three categories are not mutually exclusive. Illusory correlations arecases in which people perceive a relation between two variables when in fact there isnone, or when the perceived relation is stronger than actually exists. Data distortions areinstances in which some action by the perceiver—behavioral or mental—fundamentallychanges the data being used to assess the validity of a naive theory.The third set of perseverance-producing processes involves use of some type ofavailability heuristic in making judgments under uncertainty. In many judgment contexts,the final judgment is based on how easily, quickly, or frequently particular elements canbe brought to mind. In different judgment contexts the type of element involved in theavailability judgment varies. More importantly, in many contexts the availability of thekey elements is influenced by naive theories, sometimes directly and sometimes indi-rectly.Anderson and Lindsay (1998) suggest some solutions to knowledge structure-inducedbiases. One approach is to make an opposing naive theory available. This can be donethrough a counterexplanation process in which the person imagines and explains howa different relation is (or might be) true. Several researchers have found that this strategyworks. Another approach for reducing bias in everyday judgments involves increasingthe motivation of perceivers to come up with the right answers. Fear of invalidity is apossible explanation for reliance on naive theories for judgments. Those individuals whoare unconcerned with the validity of their judgments may resort to a quick and dirtymethod of assessment (i.e., depend on their naive theories or attitudes) rather thanconduct a more effortful evaluation of the data. In one study where participants were told



that their judgments were going to be evaluated by others made more stimulus-basedjudgments. A similar effect was found in another study, where increasing pressure to beaccurate does not always improve accuracy.When organizations do IT outsourcing, several changes take place overnight, such asownership to IT assets and employees, responsibilities, and control mechanisms. Initialbeliefs are developed by direct or indirect learning, and by causal thinking. If individualsinvolved in IT outsourcing maintain prior beliefs and expectations into the new outsourcingarrangement, this might lead to bad judgments and failure. Processing and developmentof beliefs depend on sufficient time, sufficient cognitive resources, and motivationalfactors.

Managerial Focus

Milliken (1987) has defined three types of perceived uncertainty about the environment:state, effect, and response uncertainty. People lack understanding of how componentsof the environment are changing (state uncertainty), or of the impact of environmentalchanges on the organizations (effect uncertainty), or of the response options that areopen to them (response uncertainty). Perceived environmental uncertainty is a phrasethat reminds us that perceptions matter (Weick, 1995). In a strategic managementperspective it is not difficult to see why these environmental changes matter.The work of Dutton and coauthors (e.g., Dutton, Fahey, & Narayanan, 1983; Dutton &Jackson, 1987) propose that managers categorize strategic issues as threats or oppor-tunities. Following Dutton, a strategic issue is defined as an emerging development,which in the judgment of some strategic decision makers is likely to have a significantimpact on the organization’s present or future strategies. There is no doubt thatunderstanding the factors that shape how managers interpret their strategic environmentis critically important since such interpretations ultimately affect organizational actions.Even when exposed to identical stimuli, top managers in different organizations oftenconstruct different interpretations of the same strategic issue (Meyer, 1982). In otherwords, it is reasonable to state that both cognitive processes of an organization’smembers and the contextual features of the organization influence the way managersperceive environmental changes.Smith (1995) conducted an empirical study of the classifying of managerial problems. Hedefines a category as “a class of objects that seem to belong together.” And he asks whatkinds of managerial problem categories researchers have identified? Most common arecategories reflecting business functional areas (e.g., marketing problem, finance prob-lem). Other categories suggested are situational problems (e.g., strategic issues).Problem categories play an important role in the thinking of many professionals, butcategories previously proposed in literature were rarely evidenced in Smith’s data.IT outsourcing is a strategic issue that many managers must handle and which might beperceived as an environmental uncertainty, with both opportunities and threats. By itsnature IT outsourcing affects many stakeholder groups in more than one organization,and it is likely that managers interpret their environments differently.



Persistence in Managerial Expectations

One form of outsourcing that is commonly practiced is that of spin-offs, examples ofwhich can be found in organizations such as American Airlines, Baxter Healthcare, andPhilips Electronics. In this form of outsourcing, an IT department (including theemployees, systems, and operations) within an organization gets spun-off into a separateexternal entity, becoming empowered to behave as an external vendor and having tofocus on new issues such as marketing, customer service, and offering competitive pricesto clients. In addition, the IT employees formally leave their organization and aretransplanted to the new spin-off company, which employs them and offers their servicesback to the original employer for a service fee. Even though these transplants still provideservices to the original organization, it no longer directly employs them. Instead, the spin-off company is the new employer and is responsible for the management and supervisionof these transplants, including compensating them and assigning them to specificclients. In other words, the status of the transplants relative to the original employerchanges from subordinates to third-party contractors (Ho et al., 2003).The advantages for a client organization of using transplants (as opposed tonontransplants) are numerous. Due to the transplants’ prior experience with the clientorganization, they are familiar with the operations and procedures of the organization andneed not invest as much time and effort to understand its fundamental problems andopportunities. Also, because these transplants (or contractors) are former subordinatesof the client managers, the latter should possess a deeper knowledge of contractorcompetencies and skills, and, consequently, be more effective in supervising them.There is an alternative hypothesis about the efficacy of using transplants. From theirprior experience in supervising contractors (as subordinates), client managers may havedeveloped clear expectations about what contractors should provide to the organization,such as a requisite level of work, effort, and commitment. Evidence from social psychol-ogy suggests that expectations and beliefs are not readily subject to change, even in theface of disconfirming evidence. Hence, if prior expectations persist into the IT outsourcingrelationship, client-managers would tend to think of these contractors as subordinates,imposing on them role expectations that are not appropriate under the new contractualrelationship. After outsourcing, client managers no longer possess the legitimate powerpreviously accorded them as a function of their position in the formal organizationalhierarchy. Consequently, conflicts concerning the responsibilities of contractors can(and do) arise between the two parties, which may prove difficult to resolve, and in theworst case, contribute to failure of the outsourcing arrangement.The objective of the study conducted by Ho et al. (2003) was to examine managerialattitudes and expectations toward transplants in IT spin-off arrangements. Specifically,they focused on the phenomenon of persistent expectations by exploring the conditionsunder which managerial expectations persist and the effect on managerial evaluation ofcontractor performance.Spin-offs as a form of IT outsourcing arrangement involve the use of transplants andentail a change in the relationship between the two contracting parties. Before outsourcing,the relationship is supervisor subordinate, in which supervisors have legitimate powerarising from their position of formal authority in the organizational hierarchy. Supervi-



sors can guide and influence subordinates’ work-related actions, tasks, and decisions.Moreover, the scope of their authority is fluid and not explicitly circumscribed in theemployment contract. This is reflected in the notion that subordinates have a zone ofindifference in their duties and responsibilities such that they are amenable to carryingout their duties according to supervisors’ instructions, to achieve certain organizationalor departmental goals.After a spin-off, subordinates may find themselves contracted to their former organiza-tion by the new spin-off. Several changes result from this type of outsourcing conver-sion. First, from a principal–agent perspective, the former subordinates are no longerdirect agents of the former organization but are, instead, agents of a new principal, namelythe new vendor organization. In turn, the new vendor organization contracts its servicesto the former organization (now the client organization) and, hence, operates as an agentof the client organization. Consequently, the former subordinates now work as externalcontractors to the client organization and are only indirectly the agents of the clientorganization and client managers. At the same time, client managers are no longer a directprincipal of their former subordinates (now external contractors), but instead occupy aprincipal position to the external contractors only indirectly via the relationship betweenthe client and vendor organizations.Agency theory holds that the control mechanism under a client–contractor relationshipshould also change from one that is predominantly behavior based to one that ispredominantly outcome based. In the former relationship, supervisors monitor day-to-day activities of their subordinates and rely primarily on behavior-based controls, giventhe formal authority prescribed under the employment contract and the relative ease ofmeasuring subordinate behavior. However, when the relationship changes to onebetween client and contractor, the two parties now work for two different organizations,thereby introducing the potential for goal conflict. Consequently, agency theorystipulates that the contract and the ensuing control mechanism should change to onethat is predominantly outcome based instead in order to be efficient.Second, in IT outsourcing, the contract between the client organization and the vendororganization plays a more important role, and the terms are typically more specific,explicit, and circumscribed than in an employment contract between an organization andemployees. This, in turn, implies that exchanges between the client managers and thecontractors are carried out via a more formal transaction, such that contractors are notbound to perform duties that are not specified in the outsourcing contract. Despite the overnight change in the legal relationship from supervisor and subordinateto client manager and contractor, it is likely that ex-supervisors (now client managers)will continue to perceive contractors as direct subordinates. Therefore, they will persistin imposing on their former employees (now contractors) a set of expectations that wereinternalized in their prior employment relationship, expectations that include mostly theuse of micromanagement and behavioral controls rather than predominantly outcome-based controls as prescribed by agency theory. Ho et al. (2003) posit that client managerswill expect former subordinates to perform their duties and contribute much as they didin the past, even though these duties and responsibilities may not be included in the newoutsourcing contractual arrangement.



Figure 8.2 illustrates two important gaps related to expectations. When people aretransferred, there is no reason for old expectations. This is illustrated by the curve forrelevant expectations from employment. Management may suffer from delayed aware-ness of the change, and this is illustrated by the curve persistent management expecta-tions. Each employee may perceive the stress from old expectations, and this is illustratedby the curve perceived expectations. The first gap illustrates persistent managementdelay, while the second gap represents individual perception. Each gap and the total gapmay cause serious organizational inefficiencies and personal problems for peopleinvolved.Ho et al. (2003) advanced the theoretic construct persistent expectations to describe andexplain this phenomenon. This term is adopted from the belief perseverance phenomenondescribed in the social cognition literature. Within this literature, belief perseverancetheory is particularly germane and tightly linked to the IT issue of how well managers canchange their expectations of subordinates, who, overnight, became contractors. Beliefperseverance describes the tendency for prior beliefs and expectations to persevere,even in the face of new data or when the data that generated those beliefs andexpectations are no longer valid. Research has documented that people tend to cling tobeliefs and expectations, particularly if they are well developed or if the people hadformulated explanations or naive theories to account for these perceptions. Also, priorbeliefs can affect assimilation of new data, such that people tend to interpret new dataas being more congruent with prior beliefs than they actually are.The results of two experiments conducted by Anderson, Lepper, and Ross (1980) providesupport for three general conclusions. First, they offer evidence for the basic hypothesis

Figure 8.2. Gaps in expectations

Perceived expectations

Persistent management expectations

Gap II

Gap I Relevant expectations from employment

Time

Level of expectations



that people often cling to their beliefs to a considerably greater extent than is logicallyor normatively warranted. The experiments thus extend previous research on theperseverance of specific self-assessments and interpersonal judgments to the moregeneral domain of theories concerning relationships among social variables. Second,these studies also extend prior research by suggesting that initial beliefs may perseverein the face of a subsequent invalidation of the evidence on which they are based, evenwhen this initial evidence is itself as weak and inconclusive as a single pair of dubiouslyrepresentative cases. Finally, the results provide support for the hypothesis that beliefperseverance effects may be mediated, in part, by the generation of causal explanationsor scenarios that continue to imply the correctness of one’s initial beliefs even in the laterabsence of any directly relevant evidence.Research in social cognition offers some explanation for the occurrence of persistentexpectations. It has been documented that people are generally unwilling or slow tochange established mental schemas because, as cognitive misers, we prefer to engagein automatic information processing and fit experiences into established schemas, ratherthan change our schemas to reflect changing circumstances. In fact, prior research hasdemonstrated that the need to retain established schemas is so strong that people stillwill not amend their schemas even when they are specifically informed that their priorschemas are inaccurate.Applied to the IT outsourcing context, these sociophysiological findings lend weight tothe notion that client managers do not change their old schemas and expectationsregarding former subordinates, even though the managers may recognize that these ex-subordinates are no longer officially under their jurisdiction but are under the supervi-sion of another organization. Consequently, client managers may continue to impose oncontractors’ demands and responsibilities that may not have been contracted for in theIT outsourcing arrangement. To develop a framework for the occurrence of persistentexpectations and to explore this phenomenon in greater detail, Ho et al. (2003) adopteda mixed-method approach, starting with an exploratory, qualitative case study in termsof focus groups to develop the theoretical model.Since neither belief perseverance nor persistent expectations had been examined in thecontext of a change in employment relationship, a qualitative case study approach wasselected by Ho et al. (2003) to provide critical information about the phenomenon. Thepurpose of the first qualitative phase was to obtain a richer description and understand-ing not only about the nature of the phenomenon, but also about factors affecting, andeffects arising from, persistent expectations, the organizational context in which itoccurs, and the consequences of persistent expectations. Six major themes emerged fromthe qualitative study:

1. Persistent expectations, that is, the client managers’ continued expectations of thecontractors to respond as if they were still subordinates. In terms of clientmanagers’ working relationships with contractors, client managers find it bothdifficult and awkward to manage former subordinates as external contractors.Many continue to relate to their former subordinates as if they were still subordi-nates and continue to expect the same level and quality of support and service.



2. Client managers’ experiences of role overload resulting from IT outsourcing. Interms of work concerns resulting from IT outsourcing, client managers reporthaving to perform additional duties that were previously not part of their jobrequirements and, subsequently, feel overwhelmed in their duties and responsibili-ties. While client managers have to undertake additional roles and responsibilitiesafter outsourcing, they are stripped of subordinates who previously supportedthem in completing work assignments. This results in a lack of resources neededto fulfill job responsibilities. As a result of the massive downsizing requisite in IToutsourcing, job roles and responsibilities of survivors expanded significantly tothe extent that they experience role overload. In turn, this role overload may haveamplified client managers’ persistent expectations, such that, to cope with theoverload, they continue to perceive the contractors as subordinates and expectedthem to perform duties that fall within a subordinate’s role, even though they areno longer in such a position.

3. Their strength of ties with former subordinates. Comments from client managers inthe focus groups suggest that the presence of previous ties with the contractorslikewise contributes to the persistence of expectations. Client managers indicatethat close ties with former subordinates pose obstacles to building an externalclient–vendor relationship with the contractors. Apparently, when the ties arefamiliar and both parties frequently interact, client managers persist in thinking oftransplants as subordinates.

4. Their level of trust in the contractors. In addition to experiencing varying degreesof closeness with the contractors, managers also report having different levels oftrust. Some managers have a high level of confidence in the competence and qualityof work of the contractors, and this appears to positively influence client managers’perceptions and attitudes. Some managers, however, reveal that they do not haveconfidence in the contractors’ ability. This adversely affects their degree ofreliance on the contractors. Generally, managers who do not trust the contractors’competence rely less on them and also increase their monitoring and supervision.

5. Their outsourcing experiences with other third-party vendors and comparison ofthese with those relating to the new contractors. This fifth theme that emerged fromthe focus-group discussions concerns client managers’ outsourcing experienceswith other third-party vendors and how these experiences affect the relationshipwith transplants. It appears that client managers who had prior experiences withthird-party vendors are better able to treat transplants as external contractors.

6. Client managers’ assessment of contractor performance. Persistent expectationssubsequent to outsourcing affect their judgments of contractor performance.Because client managers continue to expect contractors to perform as subordi-nates, contractors are evaluated against this higher standard and, consequently,are more severely judged. Due to the change in the formal relationship between thetwo parties, transplants should be evaluated as external contractors rather than assubordinates. However, the qualitative study indicates that some client managerscontinue to regard transplants as subordinates and expect them to perform as such.In general, client managerial expectations of subordinates are higher than those ofexternal vendors, because the exchange between supervisors and subordinates



tends to be more relational, open-ended, and broad, while that between clientmanagers and contractors tends to be more transactional, specific, and narrow.Subordinates are expected to display greater extra-role behavior and show highercommitment to work. Also, they tend to have a larger zone of indifference in theirduties and responsibilities as good employees or subordinates, because the zoneof indifference in an employment relationship is greater than that in an externaloutsourcing contract. In the IT outsourcing context, some client managers con-tinue to impose higher prior expectations on the contractors. Consequently, whenthey evaluate contractor performance in the outsourcing arrangement, they arelikely basing their evaluation on a higher set of expectations and standards, towhich contractors are less likely to have performed. Such negative rating wouldoccur even if contractors have actually provided the exact types and levels ofservice that are laid out in the outsourcing contract, which rightfully should beused as the true (but lower) basis for evaluation. Resulting biases in evaluation areexacerbated by client managers’ negative personal responses from unmet expec-tations. When client manager expectations of contractors are not being fulfilled,they will punish contractors for disconfirming expectations and lower their perfor-mance ratings.

These six major themes are illustrated in Figure 8.3. Client managers’ role overload,strength of ties, trust, and experience influence expectations that influence performanceassessment. Specifically, persistence of expectations is positively influenced by roleoverload, strength of ties, and trust in outsourcer, while negatively influenced byoutsourcing experience. This implies that persistence of expectations will be lower athigher levels of outsourcing experience. Persistence of expectations has, in turn, anegative influence on assessment of outsourcer performance, which implies that higher

Figure 8.3. Causes and effect of persistent managerial expectations in IT outsourcing

Persistence of Expectations Continued expectations of the contractor to respond as if they were still subordinates

Performance of Outsourcer Assessment of contractor performance

+

+

+

-

Role Overload Experiences of role overload resulting from IT outsourcing

Strength of Ties Strength of ties with former subordinates

Trust in Outsourcer Trust in the competence and quality of work by contractors

Outsourcing Experience Experiences with other third-party vendors and comparison of vendors

-



levels of persistence of expectation will cause lower assessment of outsourcer perfor-mance. The research model in Figure 8.3 represents assumptions or hypotheses aboutrelationships concerned with persistence of expectations. Such hypotheses can beempirically validated by collecting information from people involved in outsourcing.Following qualitative analysis in the first study of client managers’ reactions tooutsourcing and their relationships with former subordinates, the next study by Ho etal. (2003) examined persistent expectations and its empirical and statistical relationshipsto potential antecedents and consequences. They administered a questionnaire to“survivors” (those remaining) in the IT department of a large organization about 10months after the outsourcing conversion. At that time, there were 289 IT survivors in thedepartment. Persistence of expectations was measured on a scale from 1 indicatingstrongly disagree to 7 indicating strongly agree. The average score was 4.3, indicatingsome persistent expectations on average.Ho et al. (2003) found support for most of their hypotheses in Figure 8.3. Role Overload,Strength of Ties, and Outsourcing Experience had a significant influence on persistenceof expectations. Only trust in outsourcer was not found to have such a significantinfluence. Furthermore, persistence of expectations was found to have a significantinfluence on performance of IT outsourcer. These findings suggest that, althoughorganizations may radically alter the working relationships between supervisors andsubordinates, supervisory expectations of subordinates may persist despite the changein relationship. Such expectations are mental schemas—cognitive structures shaped byprior interactions, relationship building, and ingrained routines—and do not change asreadily as formal contracts. In the case of an outsourcing exercise in which employeesare “sold over” to the vendor and then “contracted back” to the same organization,managerial expectations that were based on the previous supervisor–subordinaterelationship, and operated predominantly on behavioral rather than outcome controls,remain in effect even in the new manager–contractor relationship.

Transplant Perception of Role

So far, our discussion has centered on managerial and stakeholder expectations to thetransplant. Here we will shift focus from the view of the client side to the view of the IToutsourced worker’s point of view. What psychological factors influence the percep-tions of an outsourced IT worker’s role?The perception of the role can be defined as positive when the IT worker perceives theformer employer as a client and negative when the previous colleagues are perceived ascoworkers. A scale can be thought of that runs from positive to negative, where thetransplant’s role is positive if the former employer is perceived as a client and negativeif it is perceived as the current employer. Along this scale, we can define several roles.For example, we can define supplier as a role on the positive side, coworker as a role onthe negative side, and agent as a role in the middle. Our first proposition uses the term“work overload.” This term means that a transplant does more work than is described inthe service-level agreement (SLA).



• Proposition 1: Work overload influences how the transplant perceives the role.If the outsourced IT worker does more work for the former employer than is statedin the SLA, he or she will perceive previous colleagues more as coworkers than ascustomer representatives. Therefore, the transplant will here find the roles of agentand coworker more important than the role of supplier.

• Proposition 2: Strength of ties influences how the transplant perceives the role.This proposition is concerned with the strength of relationship between theoutsourced IT worker and the former coworkers after outsourcing. If the outsourcedIT worker has strong ties to former coworkers, he or she will perceive previouscolleagues more as coworkers than as customer representatives. Therefore, thetransplant will here find the roles of agent and coworker more important than therole of supplier.

• Proposition 3: Contract discrepancy influences how the transplant perceives therole. This third proposition is about the contract or SLA. The contract is anessential part in an outsourcing arrangement. If the outsourced IT worker perceivesthat there is a considerable discrepancy between contract content and contractbehavior, he or she will perceive previous colleagues more as coworkers than ascustomer representatives. Therefore, the transplant will here find the roles of agentand coworker more important than the role of supplier.

• Proposition 4: Outsourcing experience influences how the transplant perceivesthe role. An IT worker may have previous outsourcing experience. For example, anemployee in SIG (Scandinavian IT Group) had previous experience from outsourcingwhen he was transplanted from SAS to CSC. His previous move to SIG some yearsearlier was also part of an IT outsourcing arrangement. This fourth propositionargues that if the outsourced IT worker has outsourcing experience, he or she willperceive previous colleagues less as coworkers than as customer representatives.Therefore, the transplant will here find the roles of agent and supplier moreimportant than the role of coworker.

• Proposition 5: Persistent client expectations influence how the transplantperceives the role. If the outsourced IT worker perceives that the former employerstill behaves as if the IT worker was employed, he or she will perceive previouscolleagues more as coworkers than as customer representatives. Therefore, thetransplant will here find the roles of agent and coworker more important than therole of supplier.

The outcome from these propositions is that work overload, strong ties, contractdiscrepancy, and persistent client expectations will have negative impacts on theperceived role. Only outsourcing experience will have positive impact.

Conclusions

Professional handling of personnel issues is a key challenge in managing IT outsourcingsuccessfully. Reduction in IT staff and transfer of IT staff to the vendor has to occur when



people are ready for it. Otherwise such issues are confused and escalated to employmentprotection problems and other legal issues. After transfer of staff from client to vendor,both client and vendor may gain from a transition period of old staff reducing their workfor the previous employer, thereby avoiding the problem of persistence in managerialexpectations over time.

Case Studies: Transfer of IT Employees

A thousand people in the aero deal and around 200 people in the industrial business dealwere transferred from Rolls-Royce to EDS during 1996–1997. The jobs were transferredto the outsourcer, and the terms and the conditions were transferred for a period. Thiswas done in the context of a project, where the services and the management of theservices were moved across in about 6 months. The standard process in accordance withBritish law was followed. Less than half of those original individuals were still involvedwith Rolls-Royce. EDS had a normal turnover rate, and they moved people around inprojects. There were people no longer interacting with Rolls-Royce, and there werepeople who had skills that were useful. Transfer of people in an outsourcing agreementwas an issue that EDS as a company had to be very good at. This was stated as thenumber-one risk of an outsourcer. The ability to take over the people, keep some of themon the account, and give the others opportunities to move elsewhere, was emphasizedas fundamental for the outsourcer. Another issues stated as critical, was the ability fora client to understand the skills to be retained: “You will not necessarily find themanagement skills to manage outsourcers within a client organization, because (bydefinition) they have not done that before within their internal IT.” Certainly, an ITdirector, who had previously run an IT department, might not always be the right personto run an outsourcing arrangement. It is difficult to run an outsourcer, and it was verydifferent in terms of skills.The top management of the SAS Group handled the sales process of the shares, whilethe management group of SIG handled their employees. As this was a friendly takeover,there were no immediate changes for the employees. All conditions of employment werecarried over. About 1,100 people were transferred from the SAS Group as CSC took overSIG businesses. The employees of SIG were informed about the process, the necessityof the takeover, and they got an understanding that there was no other way to keep SIGgathered in one way or the other. During the process employees did not know the nameof the bidders, but of course, there were rumors. Top management of SIG and the laborunion were involved, but lower-level employees and mid-level managers were not. Theemployees were loyal to their management and to the process, and they did understandthe reason why. Regardless of that, there was some frustration and the situation stressedthem. The sales process did not last for more than six months, but the transformationcontinued when SIG was taken over by CSC. Job insecurity was obviously an issue,because some places had a double set of managers and functions.



We joined a collective job application, without knowing to whom we applied andwithout any opportunity to influence. -Transferred IT Employee

As a consequence of the outsourcing, more than 1,200 employees were transferred fromABB to IBM. Five hundred and ten of these were transferred under the Sweden and Indiapilots, and the rest were transferred in September 2003. Because of the global deal, eachcountry had to follow its local laws for transfer of people. ABB countries had to handlethe transfer separately, involving human resource managers, labor unions, employees,and information according to local laws. In Norway for example, 35 people had to changeemployer. It was a good process where nobody quitted or got fired as a consequence ofthe outsourcing. IBM was used to taking over people and it has a procedure for how tohandle the following transformation. Old organizational structures among transferredpeople were broken down, and the employees were replaced into IBM according to theircompetencies. This meant new managers, new colleagues, and to some extent, newclients to support. According to a project executive of ABB, the quality of the technicalpeople who were transferred to IBM was generally high: “A number of them had, evenin a short period, done it extremely well at IBM.”

Governance Structures 205


Chapter IX

Governance Structures

The overall objective of this chapter is to concentrate on the important issues of strategy,structure, and management of IT outsourcing arrangements. Using well-known theoreti-cal perspectives described earlier in this book and experience earned from severalbusiness case studies in this book, we present a governance model for successfulmanagement of IT outsourcing relationships.

Perspectives on Governance

IT governance can be defined as a firm’s overall process for sharing decision rights aboutIT and monitoring the performance of IT investments. Weill and Ross (2004) define ITgovernance as specifying the decision rights and accountability framework to encouragedesirable behavior in using IT. IT governance is not about making specific IT decisions—management does that—but rather determines who systematically makes and contrib-utes to those decisions. IT governance reflects broader corporate governance principleswhile focusing on the management and use of IT to achieve corporate performance goals.Effective IT governance encourages and leverages the ingenuity of the enterprise’speople in IT usage and ensures compliance with the enterprise’s overall vision andvalues.All enterprises have IT governance. Those with effective governance have activelydesigned a set of IT governance mechanisms (committees, budgeting processes, approv-als, etc.) that encourage behavior consistent with the organization’s mission, strategy,values, norms, and culture. In these enterprises, IT can factor significantly into competi-tive strategy. In contrast, enterprises that govern IT by default more often find that ITcan sabotage business strategy.



Before we dive into IT outsourcing governance, we must look at the broader issue ofcorporate governance in enterprises. Corporate governance is concerned with govern-ing key assets, such as (Weill & Ross, 2004):

• Human assets: People, skills, career paths, training, reporting, mentoring, compe-tencies, and so on.

• Financial assets: Cash, investments, liabilities, cash flow, receivables, and so on.• Physical assets: Buildings, plant, equipment, maintenance, security, utilization,

and so on.• Intellectual Property (IP) assets: IP, including product, services, and process

know-how formally patented, copyrighted, or embedded in the enterprise’s peopleand systems.

• Information and IT assets: Digitized data, information, and knowledge aboutcustomers, processes performance, finances, IS, and so on.

• Relationship assets: Relationships within the enterprise as well as relationships,brand, and reputation with customers, suppliers, business units, regulators,competitors, channel partners, and so on.

As we can see from this list, IT outsourcing governance includes not only informationand IT assets. IT outsourcing governance is concerned with several of these assets,sometimes even all of these assets. From this perspective, IT outsourcing governancemay be as comprehensive in scope as corporate governance.In governing IT outsourcing, we can learn from good financial and corporate governance.For example, the chief financial officer (CFO) does not sign every check or authorize everypayment. Instead, he or she sets up financial governance specifying who can make thedecisions and how. The CFO then oversees the enterprise’s portfolio of investments andmanages the required cash flow and risk exposure. The CFO tracks a series of financialmetrics to manage the enterprise’s financial assets, intervening only if there are problemsor unforeseen opportunities. Similar principles apply to who can commit the enterpriseto a contract or a partnership. Exactly the same approach should be applied to ITgovernance (Weill & Ross, 2004).The dichotomy market or hierarchy has exercised a dominant influence on the study offorms of governance and their operation for some time. However, in the past two decades,there have been large numbers of investigations of intermediate forms of governance.Subsequently it has been recognized that the behavior that occurs within exchanges isnot necessarily determined by the forms of governance used, and this points to a needto understand behavior within a variety of exchanges. Blois (2002) defines governanceas the institutional framework in which contracts are initiated, monitored, adapted, andterminated. An exchange occurs between two organizations when resources are trans-ferred from one party to the other in return for resources controlled by the other party.The organization of interfirm exchanges has become of critical importance in today’sbusiness environment. Many scholars have criticized the inadequacies of legal contractsas mechanisms for governing exchange, especially in the face of uncertainty and



dependence. Other scholars argue that it is not the contracts per se but the social contextsin which they are embedded that determine their effectiveness. Cannon, Achrol, andGundlach (2000) investigated the performance implications of governance structuresinvolving contractual agreements and relational social norms, individually and incombination (plural form), under varying conditions and forms of transactional uncer-tainty and relationship-specific adaptation. Hypotheses were developed and tested ona sample of buyer–seller relationships. The results provide support for the plural formthesis—increasing the relational content of a governance structure containing contrac-tual agreements enhances performance when transactional uncertainty is high, but notwhen it is low.Cannon et al. (2000) applied the term “legal bonds” to refer to the extent to which detailedand binding contractual agreements are used to specify the roles and obligations of theparties. To the extent contracts are characterized in this way, they are less flexible andtherefore more constrained in their adaptive properties. Highly detailed contracts are alsoless likely to possess the kinds of general safeguards that are more effective in thwartingself-interest-seeking behavior under circumstances of ambiguity.Various perspectives on the nature of contracts as a mechanism of governance may befound in the literature. According to the original transaction cost framework (Williamson,1979), formal contingent claims contracts (i.e., classic contracts) are inefficient mecha-nisms of governance in the face of uncertainty because organizations are bounded intheir rationality and find it impossible to contemplate all possible future contingencies.For exchanges involving high levels of idiosyncratic investments and characterized byuncertainty, internal organization or hierarchy is predicted to be a more efficient form ofgovernance than the market (Cannon et al., 2000).However, neoclassical contract law argues that contracts can provide useful governancein exchange relationships even in the face of uncertainty and risk. This tradition ofcontract law is marked by doctrine and rules that attempt to overcome the difficultiesposed by the classical tradition’s emphasis on discreteness and presentation of ex-change. The new doctrines enable parties to respond to unforeseen contingencies bymaking adjustments to ongoing exchange and ensuring continuity in their relationships.For example, concepts such as “good faith” and “reasonable commercial standards of fairdealing in the trade” are recognized under the Uniform Commercial Code (UCC) of 1978in the United States as general provisions for contracting behavior that also help toensure continuity in exchange relationships. Similarly, “gap filler” provisions of the UCCrely on “prior dealings” between parties and “customary practices” across an industryor trading area for completing contract terms intentionally left open or omitted, thusallowing for adjustments to contingencies (Cannon et al., 2000). However, neoclassicalcontracts are not indefinitely elastic (Williamson, 1991). Many scholars remain skepticalabout how effective even the most carefully crafted contracts can be. It is argued thatthe scope for drafting rules in contracts to address changing or ambiguous conditions,or the ability to rely on general legal safeguards for controlling commercial conduct, islimited by both practicality and the law itself.Drawing on these views, Cannon et al. (2000) argue that when a transaction involvesrelationship-specific adaptations and is (1) subject to dynamic forces and futurecontingencies that cannot be foreseen or (2) involves ambiguous circumstances wheretasks are ill-defined and prone to exploitation, the difficulty of writing, monitoring, and



enforcing contracts is increased, and their overall governance effectiveness weakened.In each case, efforts to govern the relationship on the basis of detailed and formalcontracts—without the benefit of some additional apparatus—are not likely to enhanceperformance. Social or relational norms are defined generally as shared expectationsregarding behavior. The norms reflect expectations about attitudes and behaviors partieshave in working cooperatively to achieve mutual and individual goals. The spirit of suchsentiments is captured by many overlapping types of relational contracting norms. Thesecan be reduced to a core set of five (Cannon et al., 2000):

• Flexibility. The attitude among parties that an agreement is but a starting point tobe modified as the market, the exchange relationship, and the fortunes of the partiesevolve.

• Solidarity. The extent to which parties believe that success comes from workingcooperatively versus competing against one another. It dictates that parties standby one another in the face of adversity and the ups and downs of marketplacecompetition.

• Mutuality. The attitude that each party’s success is a function of everyone’ssuccess and that one cannot prosper at the expense of one’s partner. It expressesthe sentiment of joint responsibility.

• Harmonization of conflict. The extent to which a spirit of mutual accommodationtoward cooperative ends exists.

• Restraint in the use of power. Forbearance from taking advantage of one’sbargaining position in an exchange. It reflects the view that the use of power notonly exacerbates conflict over time but also undermines mutuality and solidarity,opening the door to opportunism.

Together, these cooperative norms define relational properties that are important inaffecting adaptations to dynamic market conditions and safeguarding the continuity ofexchanges subject to task ambiguity. Norms represent important social and organiza-tional vehicles of control in exchange where goals are ill-defined or involve open-endedperformance. They provide a general frame of reference, order, and standards againstwhich to guide and assess appropriate behavior in uncertain and ambiguous situations.In such situations contracts are often incomplete, and legal remedies can underminerelationship continuity. In contrast, norms motivate performance through focusingattention on the shared values of the partners to safeguard and rely on peer pressure andsocial sanctions to mitigate the risk of shirking and opportunistic expropriation. Becausethey involve expectations rather than rigid requirements of behavior, they create acooperative as opposed to a confrontational environment for negotiating adaptations,thus promoting continuity in exchange.The plural form thesis contends that exchange is best understood as embedded in acomplex matrix of economic, social, and political structures and that the governance ofexchange relations more often relies on combinations of market, social, or authority-based mechanisms than on any one category exclusively. While the plural form thesisis that the various mechanisms in fact work together to reinforce or complement one



another in some way, little attention has focused on exactly how these mechanismsactually complement one another (Cannon et al., 2000).Academic literature and business practice are directing increased attention to theimportance of creating value in buyer–supplier relationships. One method for creatingvalue is to reduce costs in commercial exchange. Cannon and Homburg (2001) developeda model that explains how supplier behaviors and the management of suppliers affect acustomer firm’s direct product, acquisition, and operations costs. The model proposesthat these costs mediate the relationship between buyer–supplier relationship behaviorsand the customer firm’s intentions to expand future purchases from the supplier, asillustrated in Figure 9.1.Cannon and Homburg empirically tested all relationships in their model. Their findingsprovide support for the expectation that more complex operational issues at times mayrequire the richer interaction provided in face-to-face communications but at other timesmay benefit from simpler written exchanges. As expected, the more standardized issuestypical of product acquisition benefit from more efficient written/electronic communica-tion. In contrast, open information sharing by suppliers was not found to be related toa customer firm’s costs. The lack of support for these hypotheses may be caused bybuying firms’ failure to use the information received from suppliers effectively. Forexample, customer firms may suffer from information overload and be unable to processand act on such information effectively. Further hypotheses in Figure 9.1 predict theeffects supplier accommodation would have on customer costs. The empirical resultssupport the prediction that greater supplier flexibility results in lower acquisition andoperations costs. Contrary to the researchers’ predictions, higher levels of relationships-specific adaptation does not lead to lower acquisition or operations costs. This may be

Figure 9.1. Model explaining how supplier affects customer costs (Cannon & Homburg,2001)

Supplier Communications

• Frequency of face-to-face communication • Frequency of telephone communication • Frequency of written communication • Information sharing

Supplier Accommodation of the Customer

• Flexibility • Relationship-specific adaptations

Characteristics of the Supplier Firm and Offering

• Product quality • Geographic closeness

Customer Cost Management

• Active monitoring of the supply market

Customer Costs

• Direct product costs • Acquisition costs • Operations costs

Customer Intention to Expand Purchases From the Supplier

Market and Situational Controls

• Product type • Availability of alternatives • Product importance • Product complexity • Age of relationship



because many of these adaptations are targeted at enhancing value through increasingthe benefits a customer receives, not through cost reduction.Whereas Cannon and Homburg (2001) developed a hypothesis that higher direct productcosts would be associated with greater supplier adaptation, the result is statisticallysignificant in the opposite direction. Several factors may explain this unanticipatedfinding. First, relationship-specific adaptations may evolve into regular business prac-tices with all customers, which may subsequently lower the cost of accommodation.Second, buying organizations may effectively bargain away the premium prices asupplier must initially charge for customized products. Finally, at a more general level,buyers may compensate suppliers through long-term commitments and/or promises ofhigher sales volume. Typically, such agreements also involve lower prices over time.As predicted in the model in Figure 9.1, geographic proximity of the supplier’s facilitieshelp lower acquisition costs. The expected effects of quality in lowering the customer’sacquisition costs and operations costs were found, but Cannon and Homburg (2001) weresurprised to find that higher-quality products had lower direct product costs. Possibleexplanations for the unexpected finding for the product quality-direct product costsrelationship can be drawn from the quality literature. It may be that quality operates asan order qualifier and high quality is necessary just to be considered as a supplier butdoes not allow a supplier to charge higher prices.Another hypothesis in Figure 9.1 predicts the effects of actively monitoring the supplymarket on each cost. More active monitoring of the supply market is found to beassociated with higher operations costs but not with higher acquisition costs. A finalhypothesis in Figure 8.1 is supported in the empirical data. It predicts that lowering thecustomer firm’s direct product, acquisition, and operations costs leads the customer toexpand its business with the supplier. These findings suggest that a supplier’s effortsto lower a customer firm’s costs can have long-term benefits to suppliers as well.As IT outsourcing becomes more commonplace, new organizational forms are emergingto facilitate these relationships. Chase Bank has created “shared services” units thatcompete with outside vendors to furnish services to the bank’s own operating units.Delta Airlines has established a “business partners” unit to oversee its relations withvendors. Microsoft outsources almost everything—from the manufacturing of itscomputer software to the distribution of its software products, thereby focusing theorganization on its primary area of competitive advantage: the writing of software code.Still other firms are creating “strategic services” divisions in which activities formerlydecentralized into autonomous business units are now being recentralized for outsidecontracting. As these various approaches suggest, the best ways to structure outsourcingremain the subject of ongoing management debate and media coverage (Useem & Harder,2000).As companies devise new forms of organization to assure that outsourcing works asintended, those responsible require a new blend of talents. Rather than issuing orders,managers must concentrate on negotiating results, replacing a skill for sending workdownward with a talent for arranging work outward. Thus, the outsourcing of servicesnecessitates lateral leadership. Useem and Harder (2000) reached this conclusion aboutleadership capabilities required for outsourcing through interviews conducted withseveral companies. What emerged from the interviews and a broader survey was a picture



of more demanding leadership environment, even as day-to-day management tasks arestreamlined by outsourcing. They found that four individual capabilities encompassmuch of what is required of managers as outsourcing becomes commonplace:

• Strategic thinking. Within the outsourcing framework, managers must understandwhether and how to outsource in ways that improve competitive advantage.

• Deal making. Outsource process managers must broker deals in two directionssimultaneously: securing the right services from external provid

• Partnership governing. After identifying areas suitable for outsourcing throughstrategic assessment and upon clinching a deal, effectively overseeing the rela-tionship is essential.

• Managing change. Forcefully spearhead change is critical because companies arecertain to encounter employee resistance.

These four capabilities emerged repeatedly when Useem and Harder (2000) were discuss-ing the essential skills of those responsible for outsourcing decisions, contracting, andoversight. None of these qualities taken singly were found to be unique to outsourcing,but their combination is critical to leading laterally.Williamson (2000) argues that governance is at level 3 in the new institutional economicsas illustrated in Figure 9.2. He defines governance as play of the game—especiallycontract by aligning governance structures with transactions. At level 1 we find thesocial environment, consisting of norms, customs, mores, traditions, and religion. Level2 is the institutional environment consisting of laws, bureaucracy, and politics. Level 4is resource allocation and employment, where we also find prices and quantities forresources and incentive alignment for employees. It is useful for the purposes ofperspectives on IT governance to study the hierarchy of Figure 9.2. The solid arrows that

Figure 9.2. Economics of institutions

Governance

(level 3)

Resource allocations

(level 4)

Institutional environment

(level 2)

Social environment

(level 1)



connect a higher with a lower level signify that the higher level imposes constraints onthe level immediately below. The reverse arrows that connect lower with higher levels aredashed and signal feedback.In the models of corporate governance literature one can organize the variety of variablesand concepts used to describe the complexity of corporate governance mechanisms intotwo main categories: capital related and related related. The capital-related aspectscontain, among others, variables such as ownership structure, corporate voting, theidentity of owners, and the role of institutional owners. The related-related aspects refermainly to the stakeholding position of related in corporate governance. Here one couldmention employee involvement schemes, participatory management, and codetermination(Cernat, 2004).

Interaction Approach

The interaction approach draws upon interorganizational theory, the marketing andpurchasing literature, and on transaction cost theory to substantiate its differentconstructs and dimensions. Figure 9.3 reproduces the basic interaction model, whichKern and Willcocks (2002) adopted from Håkansson (1982).The model focuses on both short-term episodes and general long-term relationships indyadic buyer–supplier ventures. The model recognizes that participants are commonlyconfronted with a complex pattern of interactions between and within organizations, andthat the interactions become institutionalized into a set of roles that each organization’s

Figure 9.3. Interaction approach to governance structure for outsourcing customerand outsourcing vendor

Environment Market structure, Dynamism, Globalization, Social system

Atmosphere

Power dependence, Cooperation, Closeness, Reach, Range, Affiliation

Interaction process

Organization

Client B

Organization Technology, Structure, Experience, Resources,

Strategy

Individual Goals, Experience,

Resources

Vendor A

Short-term exchanges Services, Information, Money, Social

Long-term relationships Institutionalization, Knowledge

Individual



stakeholder expects the others to perform. This process may involve different degreesof both conflict and co-operation. As illustrated in Figure 9.3, the interaction modelsuggests that the environment, in which the interaction takes place, and the atmosphereaffecting and affected by the interaction, are important variables. The interaction processis influenced by both short-term exchange episodes and long-term relationships.Environment of organizations can be described in terms of market structure determiningthe rate of change, the concentration of suppliers and buyers, and the number ofalternative relationships available for the participants; the degree of dynamism influenc-ing either party’s ability to predict and forecast changes in the market which in turn mayaffect the relationship; and social system defining the real barriers to interacting betweenorganizations. Such aspects as protocols, procedures, experiences, and ways of behav-ing when dealing with particular industries and organizations influence relations.Atmosphere of working relations between organizations can best be described in termsof power dependence, the degree of conflict or cooperation, and the overall socialdistance between the contributing organizations. In the age of electronic business, theimportant dimensions of reach, affiliation, and richness have to be included in theatmosphere construct (Evans & Wurster, 1999). Reach is about willingness to provideaccess and connection; affiliation is about whose interests the business represents; andrichness is the depth and detail of information that the business can and will give the otherorganization.Short-term exchanges are the core of the model. The goods and services bought and soldmay entail a number of risks, depending on their complexity. Information exchanges areessential and are constituted by content in technical and financial areas, media ofcommunication, and the degree of formality. Financial exchanges reveal the importanceof the relationship. Social exchanges help to reduce uncertainty, especially in situationsof cultural or spatial disparity. Formalization, trust, understanding, flexibility, andintegrity are important aspects of social exchange.Long-term relationships are concerned with institutionalization and knowledge transfer.Institutional theory seeks to explain homogeneity of organizational forms and practices.The role of institutional influence is particularly powerful in explaining organizationalphenomena in industries where well-laid-out rules, structures, external regulation, andpractices govern organizational exchanges and operations (Ang & Cummings, 1997).Knowledge transfer concerns how an organization’s individuals and internal structuretransfer their knowledge to another organization. Knowledge transfer has the purposeof improving the competence of customer and supplier (Sveiby, 2001).Informed by this interaction approach as a guiding framework, Kern and Willcocks (2002)searched for insights into the nuances of relationship practice in IT outsourcing. Theyfound several contributions the interaction approach can make to increase clarity andimproved management:

• Four exchange episodes. Practitioners have tended to become overfocused on thefinancial and service exchanges. All too often they complain of little manifestdevelopment and business optimization of the relationship, but do all too little onthe informational and social exchange fronts. Clearly, all four exchange episodesneed to be managed interactively and for the length of the contract.



• Beyond transaction or relationship-based exchanges. Relatedly, practitionerstend to see IT outsourcing in terms of a dichotomy, that is, as a transaction-basedor relationship-based exchange. However, applying the interaction approachshows that there is always a complex relationship dimension that needs to bemanaged if IT outsourcing is going to be effective for all parties.

• How to mitigate risks. A major risk that materializes often in IT outsourcing is aclient’s loss of control of the arrangements and, eventually, its IT destiny. Thefocus in the interaction approach on power dependency, commitment, cooperation,and on exchange theory shows to practitioners that dealing with certain issuesbeyond contract monitoring form fundamental ground for achieving or failing intheir managerial objectives.

• Being realistic about trust. Given that there are a lot of IT outsourcing arrange-ments self-defined variously as strategic alliances, strategic partnerships, orstrategic relationships, the interaction approach brings home to practitioners thenaïveté of the earlier notions of trust on which these seemed to be founded,resulting in contracts of insufficient detail and clarity, and an overbelief in thesuppliers’ good offices. The interaction approach offers a more complex, realisticpositioning of the role of trust amongst other influential factors, and provides thetools to show how trust needs to be earned over time, through experiences, andcannot be assumed to be in place at any time, let alone on day one.

Outsourcing research and experience recurrently emphasizes the importance of thecontract. Contracting needs careful consideration, as it is traditionally seen as thebeginning and foundation of the outsourcing relationship. Kern and Willcocks (2002)find that the interaction approach largely neglects it. Although the outsourcing relation-ship is contractually governed to ensure opportunistic behavior can be regulated at anypoint by termination, Kern and Willcocks’s study underlines that the contract is nopanacea nor does it ensure successful relations. Instead, the contract provides asubstratum; it is about getting the foundations right. Careful contract management isfundamental and entails careful monitoring of services, payments, and other require-ments and regular revisiting of the contract for updates.Kern and Willcocks (2002) find that IT outsourcing requires active management involve-ment beyond what most expect when they contract out. Traditionally, clients expect thatthe supplier takes over and delivers the service while the client stands back and monitors.However, this is a misperception. In fact, 70% of client managers’ time in postcontractmanagement is spent on managing relations. This suggests two considerations. First, itis critical for the client to establish an appropriately skilled management infrastructureprior to outsourcing, which it can implement during postcontract management. Second,the supplier needs to formalize an account team that mirrors the customer’s managementgroup. In other words, the overall contract structure should be formalized and bothparties should be aware of who their respective counterpart is.It should be a key goal of client companies to move together with the supplier towardstandardization of interactions and routine operations. Achieving what others havetermed the state of embeddedness holds the true benefits of outsourcing ventures forboth parties. For the client, it provides potential areas of where the supplier can add true



value by applying its specific technological expertise, which in a number of clientorganizations can result in reengineering programs and new technology investments.For the supplier, it entails potential opportunities for new business and hence increasedprofits. Some refer to this level of client–supplier integration as a win–win situation,where both parties benefit in their ways from the relationship. Others have explained itas the result of embeddedness, where economic actions become embedded in ongoingsocial ties that facilitate further exchange relations.The interaction approach has both potential and limitations in explaining IT outsourcingrelationships. It represents an interesting starting point for further research into iden-tifying IT outsourcing relationship practice. The interaction approach’s focus onexchange issues is highly pertinent to the study of IT outsourcing relationships, but itfurther needs to be combined with contract and transaction cost perspectives (Kern &Willcocks, 2002).

Management Control Systems

Outsourcing is a form of strategic alliance that has increased in popularity over the pastdecade. However, there is a growing body of evidence of a high failure rate in sucharrangements. One cause of this is the high level of risk associated with alliances,compared to in-house activities. Aspects that cause high risk include the difficultiesinherent in gaining cooperation with partners who have different objectives, and thepotential for opportunistic exploitation of the dependence relationship that existsbetween partners. Appropriate governance structures, including management controlsystems and the development of trust, may work to reduce risk and decrease failure(Langfield-Smith & Smith, 2003).There are several, well-established models or frameworks for studying the design ofmanagement control systems. However, these frameworks typically focus on controlsystems within organizations. It is only recently that researchers have begun to considerthe design of governance structures in situations that span traditional organizationalboundaries, including strategic alliances with suppliers, or outsourcing. These alliancesinvolve the sharing of joint decision making in areas such as strategic planning, and newproduct and process development. They may also entail joint investments in relation-specific assets. Compared to arms-length relationships, which are often well defined andcontractually based, outsourcing relationships may encompass a great deal of uncer-tainty or risk for both parties. The nature of the contract between the two parties can becomplex and cover many areas of interest that extend beyond the mere actions of supplyand receipt of goods and services. The complexity of such arrangements may precludethe complete ex ante specification of detailed contracts. In addition, the need forflexibility and adaptation in those partnerships may imply that control systems rely lesson formal mechanisms. However, in some outsourcing situations the institution of aformal control system may enable greater control and transparency, which not only mayimpact on the interorganizational relationship, but also may have implications forstrengthening control and increasing insights within the outsourcing firm.



Almost every control system involves some degree of trust that the individuals ofconcern will do what is best for the organization without any, or with only incomplete,monitoring of actions or results. Trust in governance relationships may develop overtime through processes of learning and adaptation, which are essential to the strength-ening of the relationship between partners, making the relationship more durable in theface of conflict and encouraging interactions between partners involving knowledgeexchange and promotion of each other’s interests (Langfield-Smith & Smith, 2003).A common framework for viewing the choice of governance structures in interfirmrelationships is transaction cost economics. Transaction cost economics is based on thenotion that firms choose efficient organizational forms and governance structures basedon transactional issues, such as firm-specific investments, and external and internaluncertainty. Governance structures can be characterized as one of three forms: markets,hybrids (including strategic alliances), and hierarchies (Williamson, 1991). Transactioncost economics is based on the idea that three aspects of transactions determine theappropriate mode of governance: the frequency of the transaction, the uncertaintyencompassed in those transactions, and the asset specificity of the transactions(Williamson, 1979). Asset specificity, in particular, is said to be of particular significancein explaining the choice of governance structure (Langfield-Smith & Smith, 2003). Assetspecificity is the degree to which an asset can be redeployed to alternative use withoutsacrifice of productive value. It is the opportunity loss associated with the earlytermination of a relationship. High level of asset specificity creates dependency betweenthe parties in a relationship, increases switching costs, and leads to difficult governancesituations.Three broad types of governance structures have been suggested by Williamson (1979):nontransaction-specific, semispecific, and highly specific. The market is the classicnonspecific governance structure within which faceless buyers and sellers meet for aninstant to exchange standardized goods at equilibrium prices. By contrast, highlyspecific structures are tailored to the special needs of the transaction. Identity hereclearly matters. Semispecific structures, naturally, fall in between. Several propositionsare suggested immediately. (1) Highly standardized transactions are not apt to requirespecialized governance structure. (2) Only recurrent transactions will support a highlyspecialized governance structure. (3) Although occasional transactions of anonstandardized kind will not support a transaction-specific governance structure, theyrequire special attention nonetheless.For outsourcing relationships, management control systems will, according to transac-tion cost economics theory, depend on three dimensions: task programmability, ex postinformation impactedness (output measurability), and asset specificity. Two controlarchetypes for outsourcing relationships can be specified: hybrid arms-length controland hybrid exploratory control. Langfield-Smith and Smith (2003) developed threedifferent outsourcing control patterns labeled “market-based pattern,” “bureaucracy-based pattern,” and “trust-based pattern”:

• The market-based pattern suits transactions characterized by high task program-mability, high measurability of output, low asset specificity, and high task repeti-tion. Many suppliers will compete for the contract, and market prices will be directly



linked to the quality of the output of the outsourcer’s activities. Detailed contractsare not required, and the possibility of returning to the market for competing bidsprovides discipline for the current outsourcer to provide an efficient and effectiveoutput. In the face of effective market mechanisms, no specific control instrumentsare needed to manage the relationship. The institutional environment is notrelevant, nor is supplier reputation, prior history of cooperation, and risk attitude.If one party to the relationship behaves opportunistically, another party can bechosen without high switching costs, as there are no specific investments. Thetransaction environment is characterized by low uncertainty and many availablealternative suppliers.

• The bureaucracy-based pattern, or hybrid arms-length control, suits transac-tions that have high task programmability, high output measurability, moderateasset specificity, and low to medium repetitiveness. The transaction environmenthas relatively low uncertainty, and the future is fairly predictable. Controls will beprescriptive and include detailed rules of behavior and rigid performance targets.These will be captured in detailed contracts, which are used to monitor perfor-mance. Comprehensive selection criteria are set up and formal bidding is used toselect a partner. So-called hostage arrangements can be used to ensure complianceto contractual provisions, and arbitration may be used to resolve contract disputesand to counter opportunistic behavior in an environment of moderate assetspecificity. Contracts are specific and long-term, and the autonomy of the twoparties is preserved. In this situation, a combination of behavior and outcomecontrols will be used, which is consistent with prescriptions for control systemsin the face of high task programmability and high output measurability. Trust playsa limited role in the bureaucracy-based pattern, but is important in the early stagesof a relationship. Where human knowledge and skills are critical to the quality ofthe work, the outsourcing firm must perceive that the outsourcer has high levelsof competence trust and contractual trust in order to select the outsourcer and toproceed with the contract.

• The trust-based pattern is characterized by low levels of task programmability, lowlevels of output measurability, and high asset specificity. Transactions are nothighly repetitive. The environment is highly uncertain and risky, so trust becomesthe dominant mechanism for achieving control in this form of relationship, and thismitigates the risks associated with high asset specificity. The initial selection ofthe outsourcer is based on perceptions of competence trust, contractual trust, andgoodwill trust, which arise through friendships, former contractual relationships,and reputation. Initially, contracts are merely broad frameworks, which thendevelop further over time. A series of control devices, such as personal consulta-tions and intense communications, are put in place to develop competence trustand goodwill trust. In addition, the institutional environment can stimulate thedevelopment of competence trust and contractual trust, through certification of thefirm’s activities and legal regulations. Goodwill trust becomes the solution toovercoming information asymmetry, and regular personal contacts and an attitudeof commitment can lead to its development. Control systems, in general, are moreinformal under these forms of relationships, and often take the form of socialcontrols. Behavior controls are not suited in these situations of low task program-



mability, and when controls are formalized they tend to emphasize outcomecontrols, and these develop over time through the sharing of private informationand the alignment of the parties’ performance expectations. Trust is necessary toachieve control, as activities and output cannot be measured with any certainty.

The transaction characteristics of hybrid exploratory control are similar to those oftrust-based control, except that asset specificity is moderate rather than high. High assetspecificity (as found under a trust-based pattern) cannot be tolerated under an outsourcingsituation as it increases the potential for opportunistic behavior and information leakage,requiring outsourced function to be taken back in-house. However, firms do continue toengage in outsourcing in situations of high asset specificity. The trust-based patterndemonstrates that the development of goodwill trust and contractual trust can mitigateopportunistic behavior and the abuse of unequal bargaining power. Similarly, underhybrid exploratory control, exclusive contacts with suppliers are considered unaccept-able, as they increase asset specificity, dependence, and risk in light of incompletecontracts. However, organizations do enter into exclusive contracts with outsourcers.Again, goodwill trust and contractual trust will counter the potential opportunisticbehavior.Table 9.1 contains a summary of the characteristics of the transaction, transactionenvironment, and parties for the three patterns of control, as well as the form of controlmechanisms and the role of trust in achieved control. Thus, depending on the charac-teristics of the transaction, the transaction environment and the parties, we would expectthe management control system of outsourced operations to follow one of these patterns.

Market-based pattern Bureaucratic-based pattern Trust-based pattern Transaction High task programmability

High output measurability Low asset specificity High repetition

High task programmability High output measurability Moderate asset specificity Low repetition

Low task programmability Low output measurability High asset specificity Low repetition

Transaction environment

Many potential parties All market information Social not relevant

Future known High market risks Institutional factors

Future unknown High market risks Social embeddedness Institutional factors

Parties Not important Competence reputation Medium risk sharing Asymmetry in bargaining

Competence reputation Experience in networks Experience with parties Risk-sharing attitude No asymmetry

Control mechanisms

No specific instruments Competitive bidding No detailed contracts Market prices

Outcome control Rigid performance targets Detailed rules Detailed contracts Comprehensive selection Hostage arrangements

Social controls Nonspecific contracts Performance assessed High levels of information

Role of trust Not relevant In selecting the outsourcer Perceptions of competence trust, contractual trust, and goodwill trust

Table 9.1. Control mechanisms and trust (Langfield-Smith & Smith, 2003)



Performance Measurement

As with any control or performance measure, it is necessary to develop an objectiveperformance standard for measuring the success of an outsourcing program. This leadsto four main questions surrounding the development of a standard for measuring anoutsourcing program (Milgate, 2000):

1. What was your purpose in setting up an outsourcing program? What did you wantto gain?

2. Who was this outsourcing program supposed to benefit directly? Customers?Suppliers? Employees?

3. Given the above, what should we measure?4. What can we measure? Moreover, how can we measure it accurately?

Any decision to outsource should be part of an overall business strategy. Ultimately,what will determine your measures will be your overall aims for your outsourcingprogram. If, for example, you wanted to outsource your logistics system, your purposemay be to decrease delivery times of goods to your customers. If this is the case, thenyour performance measures would be focused on the issues of meeting deliveryschedules and getting goods to customers within a certain guaranteed time frame.Customer attitudes and feelings of satisfaction are vitally important for any company.Attitudes are of general interest because attitudes are tied closely to behavior. Usingsatisfaction surveys to measure attitudes is often required.Many vendors do regular surveys of customers to measure customer satisfaction. Anexample is shown in Table 9.4, where a vendor measured a number of customersatisfaction items on a scale from 1 (strongly disagree) to 7 (strongly agree). High scorein terms of agreement is achieved for the statement that the vendor has a breadth ofproduct portfolio, while low score is achieved for the statement that the vendor is livingup to expectations. There are two curves, one for the local market and one for all Nordicmarkets.While there are a variety of techniques for reporting customer attitudes, self-reportingis the most common, probably the cheapest, and perhaps the most objective. Attitudesare usually measured using a variety of scales, such as Likert scales that attempt toquantify concepts by assigning numbers to them as illustrated in Figure 9.4. With thesenumbers, we can count different responses, prepare frequency tabulations of multiple-choice questions, and calculate percentages (Milgate, 2000).However, it is important to note that two errors can occur when we attempt to use attitudescales to understand customer satisfaction. First, merely attaching a number to a conceptin no way guarantees increased accuracy. For example, if on a five-point scale, you attach5 to very satisfied, the meaning of very satisfied to the customer is still unknown to you.



Figure 9.4. Results from a customer satisfaction survey by an outsourcing vendor

Em

ento

r No

rway’s ”P

ulse”

- com

pared

to th

e No

rdic averag

e

NB

! Com

parison based on general questions only.



While the ability to count percentages of 5s is useful in analysis, it in no way gives youthe level of understanding you really need. Second, to gain any accuracy out of attitudescales you must be sure that the questions you are asking are the right ones. This goesfor any research in general, but it is more important for quantitative research. Typically,to ensure increased accuracy of your instrument, you should either pretest the instru-ment on a selected sample of customers or construct the questions from qualitative datasuggested by customers or salespersons that deal with customers. Techniques such asfocus groups, telephone surveys, and experience surveys are useful for this. The basicrule to follow is that if you want to increase the accuracy of your satisfaction surveys,you need to have a concerted approach to research that involves the end user, a seriesof different measures and methods, and a constant review of your approach andquestions.Using satisfaction surveys and involving the end user in this process is implicit inbenchmarking. However, in the context of an outsourcing agreement, what happens if amajor technological change enables the service provider to meet customer needs morecheaply? Alternatively, what happens if a major new player comes into the market andoffers far better service than your service-level agreement requires? Essentially, how doyou set absolute standards for performance in an environment of continual change andhigh competition in which people’s self-interest is in finding better ways to meetcustomers’ needs? The answer is benchmarking. Setting benchmarks allows taking intoaccount changes in technology and monitor whether the provider is keeping up with anychanges. One should make sure that any potential supplier is innovative by constantlyinitiating best practice and by investing in its plant, staff, and any other essentialbusiness functions (Milgate, 2000).A benchmark is essentially a minimum industry-based standard that you stipulate mustbe met by your service provider. It allows you to at least keep in touch with yourcompetitors and, if constantly updated, can enable you to monitor the performancesystems. However, it does not cover all aspects of work. IT organizations provide usersupport, help desks, and may use technologies for which functional points do not apply.This measure also will not pick up maintenance and technological changes. In short, onemeasure is not enough. In addition, quantitative measures may not provide all theanswers to the questions asked nor the depth of data needed to give the IT manager asense of what is going on.Qualitative measures may be useful in several areas. Quality has to do with nuance, withdetail, with the subtle and unique things that make a difference beyond the points on astandardized scale. Quality is what separates and falls between those points on astandardized scale. Qualitative descriptions provide the detail to explain the differencebetween two people who responded on a scale of five points with a “highly” satisfactoryexperience and someone who responded that he or she had an “extremely” satisfactoryexperience. This is not a question of interval versus ordinal scaling, but one of meaning.Qualitative data can provide insights into whether the promises made by the serviceprovider actually are occurring. Satisfaction surveys represent an attempt at quantifyingattitudes or feelings. Since these factors are generally more qualitative in nature, phoningor interviewing some customers or questioning staff who receive service from theprovider can give a great deal of insight into quality issues in relation to outsourcing and



can often give a much truer picture of the level of quality than a quantitative measure can,especially when dealing with intangible items such as service.It is important to know the extent to which an IT outsourcing program is effective afterit is fully implemented. But to answer that question it is first necessary to know how andthe extent to which the program was actually implemented. One company that outsourcedwas less than impressed with the mid-term results. It bemoaned the fact that outsourcinghad not produced the results it had hoped for. However, the program had not been fullyimplemented. The company had decided to outsource in stages so as not to createantagonism amongst its staff (Milgate, 2000).

Partnering Relationships

Partnering is not new to the IS literature, and the development of partnering has beenstudied elsewhere in the management literature as well, particularly in marketing, and anumber of models have been proposed for the building and sustaining of theserelationships. Social exchange theory underlies many of the contributions. In partneringrelationships, five processes occur, where customer management can take action(Klepper, 1998):

• Attraction. This process involves rewards provided directly to the client by thevendor and rewards inherent in the characteristics of the vendor. Direct rewardsare the benefits the client receives from work done for it by the vendor in the pastand present. Vendors that carry out high-quality work within time and budgetconstraints offer higher direct rewards than vendors that do not. Vendors whosepersonnel work easily and cooperatively with personnel of the client firm offerhigher direct rewards than vendors that do not. Customer management action is tosystematically gather and centralize the information on rewards of the vendor andcharacteristics of the vendor.

• Communication and bargaining. This process involves open revelation of needsand resources related to the future of the relationship. Bargaining arises as part ofcontract negotiations with every project undertaken by a vendor, and often arisesagain when unforeseen mid-project circumstances require an adjustment of re-quirements and performance. Customer management action is to rate vendors interms of communication skills and bargaining results.

• Expectations development. This process involves actions that are beneficial to theother party in expectation that the second party will reciprocate. These expecta-tions and the actions that stem from them are based on trust. Expectations that arefulfilled build trust, and trust allows expectations to rise. Customer managementaction is to develop sets of expectations to which it will hold any partner vendor,and by providing incentives for vendors who meet these expectations.

• Norm development. This fourth process has to do with expected patterns ofbehavior in a relationship. Norms guide the actions of the client and vendor and



set the stage for further interaction. Customer management can strengthen andpromote norm development by identifying positive vendor actions as the basis forpossible norms as they occur and communicating these expectations to the vendor.

• Power and justice. This is the final process. One party has power over a secondparty if the second is dependent on the first for valued resources, and this poweris enhanced if there are limited alternative sources available to the second party.Exercise of power can be classified as just or unjust. It is unjust if the first uses itspower for its sole benefit, without the second party’s consent or understanding.It is just if both parties benefit jointly from, or if the second party is adequatelycompensated for, the exercise of the first party’s power. Customer management canexercise power in information technology outsourcing relationships throughinvestment in knowledge, practices, and assets that are specialized to the relation-ship between client and vendor.

Klepper (1998) presents four stages of partnership development: awareness, exploration,expansion, and commitment. Management processes listed above are found particularlyimportant in the exploration stage. The five processes continue to operate in theexpansion and commitment stages. Management can work through the processes tospeed the movement toward full partnering relationship in the final stage of commitmentand to maintain the partnership, once it is established.

Partnership Quality

Increasing attention is paid to building successful partnerships in IT outsourcing. Leeand Kim (1999) study the effects of partnership quality on IS outsourcing success. Theydefine partnership as an interorganizational relationship to achieve the participants’shared goals. Partnership is not a new concept in the management area. Marketing andinterorganization systems research has explored relationships between customer andvendor, buyer and seller, manufacturer and distributor, auditor and client, and so on. Anumber of different views emerged concerning interorganizational relationships.Research has classified the relationship between organizations into two types: transac-tional style and partnership style. A transactional-style relationship develops throughthe formal contract in which rules of the game are well specified and the failure to deliveron commitments by either party should be resolved through litigation or penalty clausesin the contract. In contrast, the requirements of a partnership-style relationship includerisk and benefit sharing, the need to view the relationship as a series of exchanges withouta definite end point, and the need to establish a range of mechanisms to monitor andexecute its operations.In traditional IS management, the role of a service provider was limited in terms of the sizeof the contract and the type of service. Maintenance of hardware or program subcontract-ing has traditionally been the typical IS service provider. However, the type of relation-ship in outsourcing is changing from such buyer–seller relationships to the more



strategic partnership relationship. Therefore, a necessary condition to move away fromself-interest is a belief that the exchange relationship is a win–win situation for organi-zations to gain competitive advantages.Relevant theories to analyze the interorganizational relationship include the resourcedependency theory, transaction cost theory, agent cost theory from the economicviewpoint, and social exchange theory and power political theory from the socialviewpoint. Economic theories aim at explaining the characteristics of governance orcontract. They treat each sourcing decision as an independent event regardless of priorrelationships that affect the ongoing sourcing decision. This treatment may be inappro-priate where organizations repeatedly enter transactions with each other. Explaining therelationship between organizations from a purely economic point of view is unjustifiablebecause interorganizational relationships form from the social learning experiencesbased on specific sequential interactions (Lee & Kim, 1999).Social theorists assume that processes evolve over time as participants mutually andsequentially demonstrate their trustworthiness, whereas in the economic perspective,the organization’s exchange activities are enforceable. Social theorists understandrelationship as a dynamic process through specific sequential interactions in which twoparticipants carry out activities toward one another. However, a good relationship doesnot always bring about the participants’ desired results. According to social theories,two mechanisms—trust and power—can explain the relationship between organizations.Trust, a feature of relationship quality, has been conceptualized as the firm’s belief thatthe other company will perform actions that will result in positive outcome for the firm,and will not take unexpected actions that would result in negative outcomes for the firm.Power is determined by the relative dependence between two actors in an exchangerelationship, and the concept of power is only meaningful when compared with anotherorganization. While social exchange theory uses the concept of trust to explain interac-tions between participants, power political theory relies on the power derived fromoffering valuable resources that few other sources can provide (Lee & Kim, 1999).Partnership is an effective way to improve economies of scale and scope provided by thetraditional modes of organization. However, partnership does not guarantee a desiredoutcome. Therefore, careful attention needs to be paid to the partnership problems thatmay lead to an unstable and conflicting relationship. Partnership quality is an importantconcept in this respect. Quality is treated as having two dimensions: (1) fitness of use—Does the product or service does what it is supposed to do? Does it possess the featuresthat meet the customer’s needs? and (2) reliability—To what extent is the product freefrom deficiencies? If we apply the first dimension to partnership, partnership quality maybe expressed as how well the outcome of a partnership delivered matches the partici-pants’ expectations (Lee & Kim, 1999).From this outset, partnership quality can be viewed as an antecedent of the outsourcingsuccess. High partnership quality may be a necessary condition for outsourcingsuccess, but not a sufficient condition. For instance, if the main objective of theoutsourcing was cost reduction but the outsourcing vendor failed to meet the objective,such an outsourcing project would be a failure regardless of the partnership qualitybetween the service receiver and provider. Thus, Lee and Kim (1999) distinguish theconcept of partnership quality from that of outsourcing success, and empirically testedwhether outsourcing is successful when high-quality partnership exists. They identified



the following five factors that make up partnership quality: trust (degree of confidenceand willingness between partners), business understanding (degree of understandingof behaviors, goals, and policies between partners), benefit/risk share (degree ofarticulation and agreement on benefit and risk between partners), conflict (degree ofincompatibility of activities, resource share, and goals between partners), and commit-ment (degree of the pledge of relationship continuity between partners).Partnership quality is affected by organizational, human, and environmental factors.However, most literature does not explicitly distinguish the components of partnershipquality from the factors that affect it. Lee and Kim (1999) introduced the factors fromprevious literature as potential determinants of partnership quality and presented thehypotheses related to each factor. They expected to find a positive relationship betweeneach of the hypothesized determinants of partnership quality and trust, businessunderstanding, benefit/risk share, and commitment among the components of partner-ship quality, and a negative relationship between each of the hypothesized determinantsof partnership quality and conflict.Figure 9.5 illustrates their findings. Participation was found to be significantly related topartnership quality. From a social perspective, participation is prescribed as a remedywhen there is conflict, frustration, and vacillation in the group. Active participation ofthe partnership members plays a major part in enhancing the sustainability of theirpartnerships over time. When one partner’s actions influence the ability of the other tocompete effectively, the need for participation in specifying roles, responsibilities, andexpectations increases. Accordingly, the higher the degree of participation, the higherthe quality of partnership. Communication quality was found to be significantly relatedto partnership quality. According to the social exchange literature, effective communi-cation between partners is essential in order to achieve the intended objectives.Intensive communication should lead to better-informed parties, which in turn shouldmake each party more confident in the relationship and more willing to keep it alive.Communication quality is treated as an antecedent of trust in the research literature.Accordingly, higher communication quality is believed to enhance the quality ofpartnership. Information sharing is the third significant determinant in Figure 9.5.Information sharing is the extent to which critical or proprietary information is commu-nicated to one’s partner. Partnerships can create a competitive advantage through thestrategic sharing of organizations’ key information. Closer relationships result from morefrequent and relevant information exchanges among high-performance partners. Partici-pants are expected to sustain more effective relationships over time by sharing informa-tion and by being knowledgeable about each other’s organization.Age of relationship has a significant negative effect on the partnership quality. Amongthe components of partnership quality, conflict and commitment are significantlyassociated with age of relationship. However, contrary expectations, age of relationshiphas a positive effect on conflict and a negative effect on commitment. Interestingly,mutual dependency is also negatively associated with partnership quality. This meansthat the degree of partnership quality is lower when mutual dependency is higher.Although mutual dependency has a significant effect on business understanding,benefit and risk share, and conflict, these results are contrary to the researchers’expectation. The relationship between top management support and partnership qualityis significant. Top management support also is significantly associated with trust and



business understanding, while it is not related to benefit and risk share, conflict, orcommitment.In Figure 9.5, there is a causal relationship between partnership quality and outsourcingsuccess. Successful partnership enables participants to achieve organizational objec-tives and to build a competitive advantage that each organization could not easily attainby itself. To gain these advantages of partnership, participants should try to enhancetheir partnership quality to reflect the extent of intimacy between partners. Therefore, ahigher quality of partnership is likely to lead to a successful outsourcing relationship.Outsourcing success can be viewed as the level of fitness between the customer’srequirements and the outsourcing outcomes. Lee and Kim (1999) measured outsourcingsuccess in terms of both business and user perspectives in the following way: Theyexpected to find a positive relationship between outsourcing success and componentsof partnership quality such as trust, business understanding, benefit/risk share, andcommitment, and a negative relationship between outsourcing success and conflict.From a business perspective, outsourcing is motivated by the promise of strategic,economic, and technological benefits. The success of outsourcing, then, should beassessed in terms of attainment of these benefits. Strategic benefits refer to the abilityof a firm to focus on its core business by outsourcing routine information technologyactivities. Economic benefits refer to the ability of a firm to use expertise and economiesof scale in human and technological resources of the service provider and to manage itscost structure through unambiguous contractual arrangements. Technological benefitsrefer to the ability of a firm to gain access to leading-edge IT and to avoid the risk oftechnological obsolescence that results from dynamic changes in IT. From a userperspective, outsourcing success may also be the level of quality of offered services. Adecision to outsource on the basis of saving costs without analysis of the quality ofservice frequently leads to higher costs and lower user satisfaction. Therefore, it is

Figure 9.5. Partnership quality affected by determinants and effecting outsourcingsuccess

+ + + - -

Top management support

Cultural similarity

Mutual dependency

Age of relationship

Information sharing

Coordination

Communication quality

Joint action

Participation

Determinants

Trust

Business understanding

Benefit and risk share

Conflict avoidance

Commitment

Partnership quality

Business Perspective: Achievement of strategic,

economic, and technologies benefits of outsourcing

User Perspective:

The degree of quality of offered services by the

service provider

Outsourcing success

+



imperative to conduct a proper analysis of the service quality before building arelationship with a service provider for a successful outsourcing project.In their statistical analysis, Lee and Kim (1999) found that the quality of outsourcingpartnership had a strong positive relationship with both business satisfaction and usersatisfaction, as well as with overall outsourcing success. Trust showed a strong positiverelationship with business satisfaction, while it had no effect on user satisfaction. Thisindicates that trust is a critical predictor of outsourcing success in terms of the businessperspective, as opposed to the user perspective. Unlike the result with trust, businessunderstanding was not a good predictor of business satisfaction while it significantlyinfluenced user satisfaction. This means that the outsourcing outcome matched theusers’ requirements as understanding of its partner’s business increased. Benefit andrisk share showed a strong positive relationship with both business satisfaction and usersatisfaction, as well as with overall outsourcing success. Although conflict was apredictor of business satisfaction, it had no effect on the overall outsourcing successand user satisfaction. Lee and Kim’s (1999) finding for the conflict variable indicated thatoutsourcing success was not affected by the degree of conflict between the servicereceiver and provider. Their study also indicated that commitment was significantlyassociated with outsourcing success in terms of both the business and the userperspective. In summary, all partnership quality variables except conflict were signifi-cantly related to outsourcing success.

Stakeholders

An IT stakeholder group consists of people tending to have the same expectations,perceptions, and goals for IT and outsourcing. Rather than merely categorizing peopleas either customers or suppliers, Lacity and Willcocks (2000a) identify eight types of ITstakeholders: customer senior business managers, customer senior IT managers, cus-tomer IT staff, customer IT users, supplier senior managers, supplier account managers,supplier IT staff, and subcontractors. There are four distinct customer IT stakeholders,three distinct supplier stakeholders, and one subcontractor role:

• Customer senior business managers are responsible for achieving businessresults from IT expenditures, but they often lack the tools to assess whether theIT function is adding value. They often ask senior managers for evidence ofbusiness value.

• Customer senior IT managers are typically centralized and responsible for balanc-ing the costs of IT with the services provided to ensure value for money. In general,senior IT managers are often frustrated by their charge. Users often demand serviceexcellence while their bosses often demand cost containment.

• Customer IT staff is responsible for IT service delivery. Although they are expectedto meet budgets and deadlines, IT professionals are generally technology enthu-siasts who also seek to please users. The internal IT staff is often the stakeholdergroup most profoundly affected by outsourcing.



• IT users typically focus on IT service excellence, expecting systems to be up andrunning, to provide business functionality, and to facilitate the execution of theirbusiness responsibilities. IT users rarely resist outsourcing, although they fre-quently have questions about confidentiality and integrity of data.

• Supplier senior managers are responsible for sales and negotiations. They mustbalance the need to satisfy their customers with the need to generate a profit fortheir organization. A tremendous amount of judgment, typically based on years ofexperience, is often needed to assess what can be delivered at what price while stillgenerating profit.

• Supplier account managers are responsible for profitability and customer satis-faction on a given IT contract. Again, supplier account managers must strike adelicate balance between the often-conflicting goals of service excellence and costcontainment.

• Supplier IT staff are concerned with providing good customer service. Likecustomer IT staff, supplier IT staff are generally technology enthusiasts who areanxious to please users. Sometimes their enthusiasm for customer service has tobe harnessed by their management to protect profit margins.

• Subcontractors are hired by prime suppliers to deliver part of the service tocustomers. Prime contractors often hire subcontractors to access scarce technicalskills.

These eight types of stakeholders generally hold different IT expectations and goals inoutsourcing. Some stakeholders primarily focus on IT costs because they are the onespaying for IT. Other stakeholders focus on service excellence because they are the onesusing the IT service or providing the IT service. Such diverse goals and orientationsamongst stakeholders can have a profound impact on the types of relationships that candevelop.

Hard and Soft Sides

Barthélemy (2003a) contends that IT outsourcing management has two sides. While thehard side refers to the contract, the soft side refers to trust. Both sides are keys to success.The hard side and the soft side are often used separately. The greater the contractualhazards that characterize an IT outsourcing operation, the more likely the soft side willbe preferred over the hard side. However, the hard side and the soft side can also be usedsimultaneously. In that case, the interplay between these two techniques can lead to avirtuous circle. Finally, IT outsourcing that is managed neither through the hard side northrough the soft side is doomed to fail.The hard side of IT outsourcing management refers to the development and enforcementof a good contract. Contractual quality has a huge impact on the outcome of IToutsourcing efforts as it helps protect the client from the potential opportunism of thevendor. When clients sign bad contracts, there is a risk that vendors may not provide



the expected level of service or charge excess fees for services that are not included inthe contract. A good contract is essential because it helps establish a balance of powerbetween the client and the vendor. The contract also provides incentives for valuecreation. Drafting a good contract also helps organize the relationship because it allowspartners to set expectations and to commit themselves to short- and medium-term goalsthe literature suggests a good contract must have the following characteristics(Barthélemy, 2003a):

• Preciseness. Ill-defined contracts generally result in high IT costs and poor ITservice levels. Hence, cost and performance requirements should be establishedfrom the outset and clearly specified in the contract.

• Completeness. Writing a contract, which is as complete as possible, has importantbenefits. Basically, the more complete the contract, the smaller the exposure to thepotential opportunism of the vendor and the smaller the probability that costlyrenegotiations will be needed.

• Balance. In general, one-sided contracts do not last long. Even a contract that isweighted against the vendor is not necessarily beneficial for the client. Indeed, thevendor will try to win back some value by imposing extra fees.

The actual content of a good contract will vary according to the level of contractualhazards. In IT outsourcing, the main sources of contractual hazards typically are assetspecificity and technological uncertainty. Asset specificity refers to the uniqueness ofthe firm’s hardware and software and the specialized know-how of IT employees. The softside of IT outsourcing management refers to the development of relationships based ontrust. Trust can be defined as the expectation that the vendor will not take advantage ofthe client or vice versa, even when the opportunity is available. Trust implies that bothpartners will subordinate their own interests to the joint interest of the IT-outsourcingrelationship.Management of IT outsourcing through the soft side is associated with success forseveral reasons. First, trust provides a context in which partners can achieve individualand joint goals. When an IT outsourcing relationship is characterized by trust, partnersare aware that joint efforts lead to superior outcomes. Second, trust lowers transactioncosts. The mechanisms through which the soft side mitigates contractual hazards areboth economic and sociological. Economists emphasize the rational and calculativeorigin of trust. For economists, expectations of future exchange lead to cooperation inthe present. For sociologists, trust is embedded in relationships between people.There is agreement that trust will develop only when there is some kind of risk andinterdependence between partners. When contractual hazards are low, the hard side issufficient to manage IT outsourcing relationships. Requirements can be totally specifiedup front and included in the contract. As it is easy to switch to another vendor, there isno advantage for the incumbent vendor to behave opportunistically. When contractualhazards are high, managing through the contract becomes increasingly difficult. Theclient is often captive to the relationship and not every future contingency can be knownat the time the contract is signed. The vendor may then seize these opportunities to levyadditional fees for servicing new needs. In that case, the soft side becomes crucial.



Barthélemy (2003a) studied IT outsourcing management practice. He found that 44% ofthe studied companies had hard and soft sides, 16% had hard side only, and 10% had softside only, while 30% had neither hard nor soft side. These four management types werecompared with the level of contractual hazards. The study showed that 62% of the IToutsourcing operations management through the hard side only were surrounded by lowcontractual hazards, while 60% of the IT outsourcing operations management throughthe soft side only were surrounded by high contractual hazards. This is quite consistentwith the contingency view that was advocated above.

The IT Outsourcing Governance Model

The IT outsourcing governance model consists of five elements (contracts, principles,resources, activities, and managers), two main links (terms-exchanges link betweencontracts and resources, and norms-relationships link between principles and activities),and four local links (roles between contracts and principles, capabilities betweenprinciples and resources, efficiencies between resources and activities, and outcomesbetween activities and contracts). Our governance model is illustrated in Figure 9.6.

Figure 9.6. IT Outsourcing Governance Model

Contracts

Principles

Resources

Activities Managers

Relationships Norms

Exchanges

Terms

Roles Outcomes

Capabilities Efficiencies

Contracts



Contracts provide a legally binding, institutional framework in which each party’s rights,duties, and responsibilities are codified and the goals, policies, and strategies underlyingthe arrangement are specified. Principles define decision rights concerning general ITprinciples, IT infrastructure, IT architecture, business application needs, and IT invest-ments. Resources define decision rights concerning human assets, financial assets,physical assets, IP assets, information and IT assets, and relationship assets. Activitiesdefine decision rights concerning transactions, projects, and problem solving andreporting. Managers are classified into stakeholder groups of client business manage-ment, client IT management, vendor business management, and vendor account manage-ment.Exchanges of resources occur through transactions based on contracts. Terms for useof resources are defined in contracts. Norms create expectations of behavior and implya certain action and are shared by the actors. Norms are based on principles and theyoccur in activities. Norms are concerned with flexibility, solidarity, mutuality, harmoni-zation, and power. Relationships frame activities based on principles and norms.Roles are defined by contracts and carried out when making decisions about principles.Management roles include spokesperson, entrepreneur, personnel leader, resourceallocator, monitor, and liaison roles. Capabilities enable the use of resources based onprinciples. Efficiencies are determined by the use of resources in activities. Outcomesoccur in activities that are performance results from contracts.Figure 9.7 illustrates how managers and principles are related through decision rights.General principles are high-level statements about how IT is used in the business. ITinfrastructure are strategies for the base foundation of budgeted-for IT capability(technical and human), shared throughout the firm as reliable services, and centrallycoordinated such as network, help desk, and shared data. IT architecture is an integratedset of technical choices to guide the organization in satisfying business needs. Thearchitecture is a set of policies and rules that govern the use of IT and plot a migrationpath to the way business will be done (includes data, technology, and applications).Business application needs are concerned with business applications to be acquired andbuilt. IT investment and prioritization are decisions about how much and where to investin IT, including project approvals and justification techniques (Weill & Ross, 2004).

Principle Stakeholders

General principles

IT infrastructure

IT architecture

Business application needs

IT investments

Client business management

Strategic IS planning decisions

Infrastructure capabilities decisions

Architecture performance decisions


Financial investments decisions

Client IT management

Technology business alignment decisions

Infrastructure functions decisions

Architecture structure decisions

IS decisions Investment analysis contents decisions

Vendor business management

Service-level decisions

Service organization decisions

Service organization decisions

IS organization decisions

Financial investments decisions

Vendor account management

Technology decisions

Infrastructure integration decisions

Architecture integration decisions

Technology decisions for IS

Investment analysis contents decisions

Figure 9.7. The governance model defines decision rights concerning principles



Figure 9.8 illustrates how managers and resources are related through decision rights.Human assets are people, skills, career paths, training, reporting, mentoring, competen-cies, and so on. Financial assets are cash, investments, liabilities, cash flow, receivables,and so on. Physical assets are buildings, plant, equipment, maintenance, security,utilization, and so on. Intellectual Property (IP) assets are intellectual property,including product, services, and process know-how formally patented, copyrighted, orembedded in the enterprises’ people and systems. Information and IT assets are digitizeddata, information, and knowledge about customers, processes performance, finances, IS,and so on. Relationship assets are relationships within the enterprises as well asrelationships between client and vendor at all levels (Weill & Ross, 2004).IT outsourcing governance consists of five elements as illustrated in Figure 9.7. Four ofthese elements are really dimensions of governance, while the remaining element ismanagement, which integrates the four dimensions of governance. In Figure 9.9, the fourdimensions of governance are illustrated along the time dimension, defined as theformation stage (vision, evaluation, negotiation), the operation stage (transition, im-provement), and the outcome stage (performance, results, goals, objectives).In the formation stage, contracts are concerned with transactions in the outsourcingarrangement. Later, as relationships and norms develop between vendor and client,contracts will be renegotiated, shifting focus from transactions to relationships andpartnerships. While the first contracts will be transactional contracts, later contracts willbe relational contracts. Contract work is characterized by progressive contractual work,where focus slowly shifts from transactions to relationships as contract outcomes startto materialize.It is important to design effective IT outsourcing governance. We defined governanceas specifying the decision rights and accountability framework to encourage desirablebehavior in an IT outsourcing relationship. Governance performance must then be howwell the governance arrangements encourage desirable behaviors and ultimately howwell both firms achieve their desired performance goals as vendor and client.

Figure 9.8. The governance model defines decision rights concerning resources

Resources Stakeholders

Human assets

Financial assets

Physical assets

IP assets Information and IT assets

Relationship assets

Client business management

Knowledge management decisions

User investment decisions

Tangible assets policy

Intangible assets policy


Information-sharing policy

Client IT management

Internal IT personnel decisions

User technology investment

decision

Tangible assets management

Intangible assets management

Technology business alignment decision

Project sharing policy

Vendor business management

Knowledge management decisions

Vendor investment decisions

Tangible assets governance

Intangible assets governance

Service-level decisions

Competence-sharing policy

Vendor account management

Internal IT personnel decisions

Vendor technology investment decisions

Tangible assets governance

Intangible assets governance

Technology decisions

Knowledge transfer policy



Early on in this book, we presented several IT outsourcing theories. Each theory impliessuggestions for managing successful IT outsourcing relationships. As a total set ofsuggestions and ideas from all theories, these guidelines represent critical successfactors after outsourcing, as illustrated in Chapter IV. The guidelines can be implementedin the governance model as illustrated in Figure 9.10. We see that resource-based theoryand theory of firm boundaries both provide guidelines for resource management.Alliance and partnership theory and relational exchange theory both provide guidelinesfor principles management. Transaction cost theory, neoclassical economic theory, andsocial exchange theory all provide guidelines for activity management, while contractualtheory provide guidelines for contract management. Theory of core competencies,agency theory, and stakeholder theory provide guidelines directly to managers in chargeof the outsourcing arrangement.Based on outsourcing theories and practice, we are able to list the following key successfactors for a sourcing firm (client) and a source firm (vendor), as listed in Figure 9.11 andFigure 9.12, respectively.

Figure 9.9. Stages of growth in IT outsourcing

Contracts

Principles

Resources

Formation Stage Operation Stage Outcome Stage

Activities

Negotiations for transactions

Development of norms

Renegotiations for partnerships

General principles IT infrastructure

IT architecture IT investments

Business application needs

Physical assets Financial assets

IT assets IP assets

Human assets Relationship assets

Transactions Projects Knowledge exchanges



Figure 9.10. Managing successful IT outsourcing relationships through the governancemodel based on IT outsourcing theories

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Theory How to succeed as a client company in an outsourcing arrangement

Theory of core competencies We have to define our IT needs and manage IT services from the vendor.

Resource-based theory We have to integrate and exploit strategic IT resources from the vendor together with our own resources to produce competitive goods and services.

Transaction cost theory We have to minimize transaction costs by reducing the need for lasting specific IT assets; increase transaction frequency; reduce complexity and uncertainty in IT tasks; improve performance measurements; and reduce depend-ence on other transactions.

Contractual theory We must have a complete IT contract based on information symmetry in a predictable environment with occurrence adaptation that prevents opportunistic behavior in an effi-cient collaborative environment with balance of power be-tween client and vendor, where the contract is a manage-ment instrument that grants decision rights and action du-ties.

Neoclassical economic theory We have to integrate and exploit IT services from the ven-dor together with our own services to produce competitive goods and services.

Partnership and alliance theory We have to develop experience with alliances, develop alliance managers, and develop the ability to identify poten-tial vendors.

Relational exchange theory We have to develop and secure common norms that are relevant to both parties.

Social exchange theory We have to enable social and economic outcomes in the exchange between the vendor and us such that these out-comes outperform those obtainable in alternative ex-changes.

Agency theory We have to make it easy and inexpensive for ourselves to find out what the vendor is actually doing. In addition, both outcome-based and behavior-based incentives can be used to reduce and prevent opportunistic vendor behavior.

Theory of firm boundaries We have to implement a strict and rigid division of labor between the vendor and us.

Stakeholder theory We must create efficient and effective communication with and between stakeholders to secure continued support from all stakeholders, to balance their interests, and to make the IT outsourcing arrangement so that all stakeholders achieve their goals.

Figure 9.11. Key success factors for the client in managing successful IT outsourcingrelationships based on theories

Conclusions

The interaction approach to outsourcing governance focuses both on short-termepisodes and general long-term relationships in dyadic buyer–supplier ventures. Inaddition, to understand and apply a general governance approach, management controlsystems have to be implemented. Regular performance measurement should be con-ducted, including measurement of partnership quality. Professional partnering relation-



Theory How to succeed as a vendor company in an outsourcing arrangement

Theory of core competencies We have to provide complementary core competencies, such as personnel, methodologies, and services, to the client.

Resource-based theory We have to enable the client to integrate and exploit strategic IT resources from us together with the clients’ own resources to produce competitive goods and services.

Transaction cost theory We have to minimize transaction costs by reducing the need for lasting specific IT assets; increase transaction frequency; reduce complexity and uncertainty in IT tasks; improve per-formance measurements; and reduce dependence on other transactions.

Contractual theory We must have a complete IT contract based on information symmetry in a predictable environment with occurrence adap-tation that prevents opportunistic behavior in an efficient col-laborative environment with balance of power between client and vendor, where the contract is a management instrument that grants decision rights and action duties.

Neoclassical economic theory We have to enable the client to integrate and exploit IT ser-vices from us together with own services to produce competi-tive goods and services.

Partnership and alliance theory We have to develop experience with alliances, develop alli-ance managers, and develop the ability to identify potential clients.

Relational exchange theory We have to develop and secure common norms that are rele-vant to both parties.

Social exchange theory We have to enable social and economic outcomes in the ex-change between the client and us such that these outcomes outperform those obtainable in alternative exchanges.

Agency theory It must be easy and inexpensive for the principal (client) to find out what the agent (vendor) is actually doing. In addition, both outcome-based and behavior-based incentives can be used to reduce and prevent opportunistic behavior.

Theory of firm boundaries We have to implement a strict and rigid division of labor be-tween the client and us.

Stakeholder theory We have to create efficient and effective communication with and between stakeholders to secure continued support from all stakeholders, to balance their interests, and to make the IT outsourcing arrangement so that all stakeholders achieve their goals.

Figure 9.12. Key success factors for the vendor in managing successful IT outsourcingrelationships based on theories

ships have to develop through attraction, communication and bargaining, expectationsdevelopment, norm development, and power and justice.

Case Studies: Governance Structures

Rolls-Royce had a small corporate staff doing IT and that covered the architecture, theoversight of projects, and the management of service levels. And they were relativelysenior people. Rolls-Royce owned the project management overall, and it also owned the



IT architecture. It had an IT procurement team that was part of the procurement unit, buthad a functional accountability to the IT community. There was a tight top-managementrelationship between the two parties. The CIO of Rolls-Royce met EDS board membersonce a year for a couple of days, and they discussed the progress of the contract andthe overall relationship in a formal sense. Rolls-Royce also had a hot line, where the CIOcould pick up the phone and get straight through to the CEO of EDS if something wasdisastrous. There were regular monthly meetings between the CIO of Rolls-Royce andthose at EDS who oversaw the accounts of EDS. One of them was account manager andthe other was responsible for all the projects and all the services. In addition, there werea number of meetings. There were commercial review boards, the review on expenditure,and service review boards that manage the quality of the services against the service leveland the individual performance of the projects. Where the services were provideddirectly to Rolls-Royce lines of business, the IT head in the businesses would work outwhat was needed for the business and would reflect that back to the central IT unit, whichin turn brought this back to EDS. Thus, the lines of business had a stake in defining thestandards. However, managing the services was done centrally. Rolls-Royce found thatwhen EDS was attempting to manage all the services and interacting with all the businessdivisions, it actually got quite complicated and expensive in terms of manpower. So, themanagement of the services on a day-to-day basis took place from the center withexperienced service management teams from Rolls-Royce.Rolls-Royce had more than 70 IT employees in an in-house team in the commercial marinebusiness, and this team was a self-efficient group mainly serving its own division. Butthe in-house team was also involved in some of the central project, and thus it cooperatedwith EDS to some extent. Rolls-Royce had a benchmarking process built into the contractwhere it could take the services to a third party to benchmark against other companies.However, it had found that to be somewhat unsatisfactory, because it was very difficultto compare like with like, apples with apples. The in-house IT department kept in thecommercial marine division gave a value assurance, in the sense that it knew the costsof having its own people to do the services, which gave Rolls-Royce an opportunity tomeasure that against the outsourcer.In the SAS–CSC case, a steering committee was established for an overall governanceof the relationship. The committee had three members from SAS and two members fromCSC. From the client side, the participants were the CIO, a vice president representativeof airline business, and the manager of IT purchasing. From the vendor side, theparticipants were the account executive and operations manager. Also established weresome functional groups reporting to the steering committee, and they were working withstandardization, security, and so forth. Each business unit in SAS had a relationship withCSC as the responsibility for IT services and costs were delegated to the consumers ofIT services.ABB realized that outsourcing relationships might be extremely dynamic, which was oneof the reasons why it tried to develop a contract and a governance approach to thesecontracts that itself was dynamic. As a client manager at ABB stated, “Within 10 yearsABB will be a different company than it is today, and so is technology.” A real challenge,as one manager put it, was “How on earth do you develop a contract and a relationshipto satisfy a violent cost-reduction environment, but also at the same time to serve abusiness expansion environment?” Despite this, the governance model put in place was



rather simple. Basically, it was local meetings with global escalating. Each country wasresponsible for its own operations (service levels) and financials. Take Norway as anexample; there were two meetings each week between ABB and IBM. First, there was theoperational meeting, where technical personnel met. Second, there was the commercialmeeting, where project executives met. The intention of the deal was that everything wasto be solved locally. Each month, every country reported its costs to headquarters. Andonce a month, there was the project executive meeting, either by phone or in person, inwhich all the country executives participate.Poppo and Zenger (2002) argue that contracts and relational governance are notsubstitutes but complements. They find that relational exchange arrangements sup-ported by trust are commonly viewed as substitutes for complex contracts ininterorganizational exchange, and that many argue that formal contracts actually under-mine trust and thereby encourage the opportunistic behavior they were designed todiscourage. The initial outsourcing contract between Rolls-Royce and EDS was one infull dimension. But there was a lack of transparency, which provided a potential formistrust. Of course, when something was going wrong, the contract played an importantrole. The contract was reviewed in 2000, and the parties were putting a new long-termarrangement in place and built a pretty close relationship. High degree of transparencyof difficulties such as finance should remove mistrust.Relational exchange theory is based on relational norms relevant to both parties. Normsdetermine behavior and are mainly concerned with flexibility, information exchange, andsolidarity, and they secure integration in the relationship. The relationship alignmentproject of ABB and IBM was seen as a key success factor to create and maintain a goodworking relationship between the two parties. The objective of the project was (amongothers) to create a framework to manage the natural tension between both parties, to findan agreement on a vision of how the parties needed to work together, to build a strongworking relationship between the teams in the various countries, to build and commit toan appropriate strategic relationship structure and enabling mechanisms, to support agroup-wide collaborative approach, to review and refine roles and responsibilities, andto align across all countries.

Costs, Benefits, and Risks 239


Chapter X

Costs, Benefits,and Risks

A dominant explanation for companies outsourcing IT is costs. In this chapter, wediscuss production and transaction economics, hidden costs and contract terminationcosts, and we will also examine benefits and risk behavior.

Production and Transaction Economies

The neoclassical economic perspective of a firm regards an organization as a productionfunction motivated by profit maximization. The choice of alternative IT sourcing arrange-ments is thus treated as a traditional make-or-buy decision, hinging on efficiencyconsiderations of production costs savings or operational advantage. Seeking economicefficiency, firms will attempt to obtain all factors of production at the lowest possibleprice to achieve the least costly methods of operations. From this theoretical standpointof production economic efficiency, the decision to outsource IS services is determinedby the relative production costs of market versus internal operations. Since IT providersmay reap economics of scale via specialization or possess special skills, knowledge, ortechnology in managing and operating IT, we would expect that the greater theproduction cost advantage of IT service providers, the more likely the firm will outsourceits IS services (Ang, 1993).Transaction cost economics extends the neoclassical economic perspective of the firmby contending that market transactions are not frictionless. Transaction costs are thosecosts incurred to ensure proper execution of the contracting process. Transaction costsinclude the costs of creating and maintaining an exchange relationship, that is, the effortin negotiating, writing, monitoring, and enforcing contracts between buyers and theirsuppliers. Although outsourcing may yield production cost savings by exploiting scale



economies in outsourcing, additional costs in the form of transaction costs are incurredwhen a firm enters into an outsourcing relationship with a service provider. Accordingly,transaction cost economics posit that, in addition to production cost efficiencies,transaction cost efficiencies must be considered in evaluating alternative organizationschemes. From the transaction cost perspective, economic activities are governed by themarket, hierarchies, or a hybrid form. Transaction cost economics posits that sourcingdecisions for IS services are based on transaction costs. For example, even if a particularexternal IT service provider can provide IT operational services at the most competitiveprice, if the same provider requires a great deal of supervision and monitoring during thecourse of the contract, the advantages of a cheaper price may be eroded by the excessivemonitoring costs incurred by the firm. Here, excessive transaction costs can cause marketfailure. Thus, as market exchanges and firms lose their production cost advantage totransaction diseconomies, firms would turn to internal sourcing to meet their needs.Therefore, we would expect that the higher the transaction costs with IT serviceproviders, the less likely the firm will outsource its IS services (Ang, 1993).Transaction cost theory maintains that the organization of economic activity dependson balancing production economics, such as scale, against the cost of transacting.Transactions are here the exchanges of goods and services between economic actors,who are technologically separate units, inside and/or outside the organization (Williamson,1981). The analysis of transactions focuses on achieving efficiency in their administra-tion. In this perspective, organizational success depends on managing transactionsefficiently. Organizations exist to mediate the economic transactions among membersinside and/or outside the organization. The transaction cost approach offers a methodof evaluating the relative advantages of the different internal and external organizationforms for handling transactions. This theory also provides an excellent framework foranalyzing the outsourcing options, since the essential choice here is between using anoutsourcing service provider (a market mechanism) and providing in-house services (anorganizational hierarchy). First, the theory seems to very useful for investigating theoutsourcing option as an economic reorganization of IT departments. Second, the theoryappears to be useful for formulating an action plan to reduce transaction cost and therebyimproves the benefit one can realize through outsourcing (Grover et al., 1998).A focus on comparative economic theories and models can improve our ability to explainoutsourcing within the larger context of business strategy and environment. Specifically,productions cost, transaction cost, and financial slack often influence the outsourcingdecision (Ang & Straub, 1998):

• Production cost advantage. Neoclassical economics regards any business orga-nization as a production function motivated by profit maximization. Organizationsprovide goods and services to markets where they have cost advantages and relyon the marketplace for goods and services in which they have comparative costdisadvantages. Neoclassical economics predicts that firms justify sourcing op-tions based on production economies. In terms of production economies, acquiringgoods and services is treated as an economic make-or-buy decision—a decisionthat compares production costs of internal operations with the price offered in themarketplace. In the context of IS, a firm will choose to outsource or insource basedon the comparative costs of internalizing IS versus the price it has to pay vendorsfor the same IS services. Production economies suggest that the higher the



comparative production cost advantage offered through IT outsourcing, thegreater is the degree of IT outsourcing.

• Transaction cost advantage. Transaction cost economics extends the neoclassi-cal economic perspective of the firm by recognizing the significance of transactioncosts in any market exchange. Transaction costs refer to the effort, time, and costsincurred in searching, creating, negotiating, monitoring, and enforcing a servicecontract between buyers and suppliers. Transaction costs can erode comparativeadvantages in production costs of vendors. When a firm has to incur substantialeffort and costs in supervising, coordinating, and monitoring the activities of thevendor, it may decide that external sourcing is too costly. Accordingly, firms mayopt for internal sourcing when they perceive transaction diseconomies to overrideany production cost advantages in market exchanges. Transaction economiessuggest that the less the transaction costs involved in hiring outsource, the greateris the degree of IT outsourcing.

• Financial slack advantage. The sourcing conundrum may also be explained by afirm’s discretionary use of financial slack. Financial slack refers to financialresources in excess of what is required to maintain the organization. Slack can bedefined as the difference between total financial resources and necessary pay-ments or as a cushion of excess resources available in an organization that willeither solve many organization problems or facilitate the pursuit of goals outsidethe realm of those dictated by optimization principles. When organizations possessslack resources, firms may enlarge the scale and scope of their operations bydeploying slack resources toward building up internal IT resources in the form ofhardware, software, and IS human resources. Conversely, when slack resources arelow, firms are likely to resist internalizing in response to the anxiety provoked byloss of financial resources. Thus, when slack resources are low, firms can beexpected to downsize internal IS services by selling off IT assets and reducing ISpersonnel expenses. Financial economies suggest that the less financial slack, thegreater the degree of IT outsourcing.

To empirically test these relationships between economies and outsourcing, Ang andStraub (1998) gathered information from senior IT managers in 243 U.S. banks. Resultsfrom the study show that IS outsourcing was strongly influenced by production costadvantages offered by vendors. Transaction costs played a role in the outsourcingdecision, but they were much smaller than production costs. Finally, financial slack wasnot found to be a significant control factor.Ang and Cummings (1997) conducted a similar test on the same information gathered fromsenior IT managers in 243 U.S. banks. Commercial banks in the United States operate inhighly institutionalized environments. Historically, stringent banking legislation re-stricted operations and suppressed competition. In recent years, regulation that formerlyhad fended off competition from other financial institutions weakened. As banks searchfor ways to grow and maintain their competitive edge, outsourcing emerged as a dominantorganizational strategy for achieving those goals. In their empirical study, Ang andCummings suggest relationships between institutional influence and IS outsourcingfrom external production cost advantage, level of slack resources in a bank, andspecificity of IS assets. Institutional influences on IS outsourcing come from both peer



banks and federal regulators. Peer banks exert considerable influence on each otherbecause of tight professional networks formalized by memberships in regional andnational bank associations. Federal regulators exert substantial influence on bankpractices and operations.Ang and Cummings found that the greater the external production cost advantage, thestronger the relationship between institutional influence and IS outsourcing. Thisfinding suggests that the effect of external production cost advantage on the relationshipof peer influence to outsourcing is different between large and small banks. Subsequentanalysis showed that the cost advantage significantly strengthened conformity to peerinfluence for IS outsourcing in large banks and not in small banks.Ang and Cummings also found that the lower the level of slack resources in a bank, thestronger the relationship between institutional influences and IS outsourcing. Con-versely, the higher the level of slack resources in a bank, the weaker the relationshipbetween institutional influences and IS outsourcing. Subsequent analysis showed that,regardless of bank size, conformity to peer influence for IS outsourcing was weakenedwith increasing perceived slack resources.Ang and Cummings’s third finding was that the greater the specificity of IS assets, theweaker the relationship between institutional influences and IS outsourcing. Thisfinding suggests that the effect of specific assets on the relationship of peer influenceto outsourcing is significantly different between large and small banks. Subsequentanalysis for large and small banks showed that specificity of IS assets significantlyweakened conformity to influence for peer outsourcing in large banks and not in smallbanks.Several implications can be derived from this study. From a managerial perspective,recognition of strategic economic considerations is important. Hence, organizationsshould be cautious when imitating strategies or when learning vicariously from theexperience of peers. Especially for small organizations, which tend to exhibit substantialfollower behavior, more proactive evaluation of the efficiencies and effectiveness ofalternative organizational arrangements is warranted to ensure a timely strategic re-sponse to the environment (Ang & Cummings, 1997).Production and transaction economies through supply and demand forces place inperspective the interesting conflict of a reluctant organization striving to maintain itsindependence from others while knowing that it must assent to interorganizational tiesto procure the resources needed. Outsourcing poses challenges to both user organiza-tions and service providers: in estimating the “true” costs and saving of outsourcing;in managing power dependencies in the exchange; and in balancing the opportunitiesoffered by open boundaries and free-flowing information against the need to protect theorganization’s unique capabilities. The study by Ang and Straub (1998) was an attemptto compare the relative effects of production and transaction costs on managerialoutsourcing decisions in the IT context. Both production costs and transaction costs canand, it is argued, should have a major impact on decisions to outsource. Managers needto be especially vigilant to see that estimates of both kinds of costs figure into theircalculations of returns on investments.Aubert, Rivard, and Patry (2004) applied transaction cost theory to formulate fourhypotheses about the level of outsourcing of IT operation activities. The first pertains



to asset specificity. Transactions requiring specific assets will bear higher transactioncosts; hence they will be more likely to be retained in-house. Hence, the degree of assetspecificity will have a negative effect on the level of outsourcing of IT operation activities(hypothesis 1).The second hypothesis assumed that uncertainty would be a deterrent for organizationstrying to outsource IT operation activities. The difficulties associated with writingcontracts or with measurement will induce them to prefer internal governance for highlyuncertain activities. Hence, the level of uncertainty will have a negative effect on the levelof outsourcing of IT operation activities (hypothesis 2).Finally, the last two hypotheses are related to the origin of the investments. Two typesof skills are required to carry any given activity. Business skills refer to the knowledgeof the business environment of the firm, while technical skills are more related to thegeneric components of a given activity. Activities presenting a high level of businesscontent should be kept in-house, because the members of the organization are more likelyto master the content. Conversely, highly technical activities should be outsourced,since suppliers can nurture the critical technical skills. Hence, the amount of businessskills required to perform IT operation activities will have a negative effect on their levelof outsourcing (hypothesis 3). And the amount of technical skills required to perform IToperation activities will have a positive effect on their level of outsourcing (hypothesis4).Aubert et al. (2004) collected data from three sources and conducted a statistical analysisto test relationships as illustrated in Figure 10.1. The most surprising finding is the linkbetween asset specificity and the outsourcing level. It was anticipated that the presenceof specific assets would deter companies from outsourcing IT activities. The resultobtained suggests the opposite. The link between asset specificity and outsourcing levelis strong and significant. As anticipated, increased technical skills tend to favoroutsourcing. Similarly, the presence of uncertainty and measurement problems seems topreclude outsourcing of IT activities. Overall, 19.4% (R squared) of the variance wasexplained.The objective of the study by Aubert et al. (2004) was to test an explanatory model ofIT outsourcing behavior. Based on transaction costs and incomplete contract theories,

Figure 10.1. Results of causal statistical analysis to explain outsourcing level

Asset specificity

Uncertainty

Business skills

Technical skills

Outsourcing level

.374*

-.142*

-.055

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the model embedded hypotheses that constitute the foundations of these theoreticaldomains. The results obtained support, at least in part, the transaction cost model. Fromthe results, it was clear that uncertainty and measurement problems play a role in the IToutsourcing decision. Firms outsource more readily activities having low uncertainty.These results support the transaction cost hypothesis. The market is seen as lessefficient to ensure the execution of transactions prone to high uncertainty or severemeasurement problems. The internal governance is a more efficient alternative. Thepresence of technical skills was positively related to the outsourcing decision. Itsupports the idea from incomplete contract theory stating that activities should be underthe control of the party making the critical investment for the transaction. However,business skills did not seem to play a significant role in the decision to outsource. It maybe attributed to the rather low level of business skills required to perform IT operations.Asset specificity showed conflicting results, suggesting that more specific assets leadto more outsourcing. This contradicted the transaction cost hypothesis.

Hidden Costs

The hidden management costs in outsourcing relationships are identified in researchconducted by Kern and Willcocks (2002). Three areas of hidden costs are identified,which receive little attention at the outset by client companies. First, the significant costsinvolved in postcontract management are not planned for. The findings suggest thatmanagement resorting to develop and maintain relations is generally higher than initiallyanticipated and expected. The split of management time on relationship management andthe rest, that is, contract management is 70–30. Second, ongoing monitoring costsgenerally are not considered. These arise due to the client’s management agenda ofassuring not only that the vendor keeps its commitment to deliver the agreed services,but also to control the costs of the deal. Finally, the renegotiation or update costsinvolved in ensuring the contract always reflects the current statutes of the IT outsourcingarrangement. This is essential to ensure, for example, that in the event of termination, allservice levels, technological assets, and staffing are listed to simplify insourcing orvendor switch. Planning a contract that caters for every contingency is generallyimpossible in long-term business deals. Hence, outsourcing contracts, like so many otherlong-term business contracts, suffer from an inherent incompleteness and hence neces-sitate updating.Overlooking hidden costs of outsourcing was listed as the sixth deadly sin of outsourcingby Barthélemy (2003b). In a separate article, Barthélemy (2001) discusses the varioushidden costs of IT outsourcing. Most companies outsourcing IT for the first time are notaware of those costs. Companies say they entered an outsourcing agreement believingthat they understood all major costs. They agree that some amount was needed foractivities such as finding a vendor, drafting the contract, and managing the effort, butthey think the amount would be negligible—in some cases, they halved or even canceledout the company’s potential savings from outsourcing. Only those companies that havea bad experience take preventive measures. Barthélemy (2001) identifies four categoriesof hidden costs:



1. Vendor search and contracting. Many enterprises underestimate the expense toidentify and evaluate suitable IT vendors, select a finalist, and negotiate and draftthe contract. Companies incur such costs before spending the first dollar on theactual work. Thus it costs something just to think about IT outsourcing. Companiesmay not want to reduce their spending for search and contracting, because it cansignificantly lower the other hidden costs. Additional time and expense early onhelps avoid problems later, such as having to renegotiate the contract or constantlymonitor the vendor to achieve the needed performance.

2. Transition to the vendor. Switching in-house IT activities to a vendor presentsprobably the most elusive hidden cost. Most companies do not realize how muchthey have spent until the transition is complete. It can take months before thevendor knows as much as the internal IT department, and it is hard to say exactlywhen the vendor has taken over. Most managers are unable to analyze transitioncost. The best they can do is report transition time; a measure offering only limitedinsight into what drives transition cost. The average transition period—when theorganization actually incurred a cost—was about a year. Transition costs areelusive: a company incurs them as long as the vendor has not completely taken overfrom the internal IT department. The time that internal employees spend helping thevendor is transition costs. Costs that stem from disruption—and from the vendor’sinability to react as quickly and appropriately as the internal department did at thebeginning of the contract—are transition costs. The characteristics of theoutsourced activity greatly influence transition cost. The more idiosyncratic theactivity (the more tailored for the specific company), the higher the cost to pass itto a vendor that must take time to learn the activity. Outsourcing commodities suchas PC procurement and maintenance entail lower transition costs. Also, the morecomplex the outsourced activity, the harder the transition. Furthermore, outsourcingactivities that require transferring many people to the vendor also increasetransition costs. The transferred employees often feel betrayed. They can resistoutsourcing initiatives either directly (e.g., strike) or indirectly (e.g., slow motion).

3. Managing the effort. Managing the effort probably represents the largest categoryof hidden costs because it covers three areas: monitoring to see that IT vendorsfulfill their contractual obligations, bargaining with IT vendors (and sanctioningthem if necessary), and negotiating any needed contract changes. Unlikeoutsourcing fees, vendor management costs for IT outsourcing are not readilyapparent. A company knows what it pays to the vendor. Indeed, many businessesoutsource to find out how much they pay for IT. Management costs, in contrast,are purely internal. Because of the costs’ relative obscurity, many companies donot take them into account until they become visible—usually when the overalloutsourcing cost has noticeably escalated.

4. Transitioning after outsourcing. The fourth hidden cost comes form switchingvendors or reintegrating IT activities internally. When activities must be redirectedto a new vendor, the cost involves finding that vendor, drafting a new contract, andtransitioning resources. When activities must be reintegrated, the cost involvesbuilding a new internal IT activity from scratch. The time needed is roughly the sameregardless of the kind of transition. Such hidden costs represent expenses thatmanagers find hard to quantify. Most managers are reluctant to think about the end



of the contract. Outsourcing IT to focus on a company’s core business or to cutcosts is generally meant to be permanent. Companies do not plan to reintegrate IT.Even switching vendors is a move they prefer to avoid. Thus, regardless of howthe contract ends, the end signifies a failed outsourcing effort. Most managers findit hard to consider that possibility.

All too often, companies neglect the hidden costs of IT outsourcing. Overlooking hiddencosts is unwise. A better approach is to manage the four costs proactively and holisticallyand to spend extra time and resources in the early stages of the outsourcing effort.Knowing what the company wants and spending time on the contract can help curb thecost of managing the initiative and of transitioning outsourced activities when thecontract ends (Barthélemy 2001).

Contract Termination Costs

An emerging area for debate between customers and suppliers is which of them bears therisk of prospective redundancy costs at the end of a contract where there is no transferof an undertaking, and therefore no transfer of the supplier’s staff assigned to theundertaking. This is an issue of real commercial significance as customers become moreprepared to change suppliers, and since the sums involved can be quite significant(Foster, 2003).When a supplier bids for an outsourcing contract, it should take into account all costsconnected with the take-on of the contract, and also those costs arising from expirationor termination. It will probably assume that it is able to cease paying sums (e.g., licensefees, lease rentals, maintenance costs) to third-party suppliers for goods and servicesconnected with the contract at the point, when, at the end of the contract, it ceases toreceive revenue from the customer to cover this expenditure. But this still leaves onemajor area of cost to the supplier where the costs cannot be turned off quite so easily—the costs related to the ongoing employment or termination of employment of the staffthat have hitherto delivered the service to the customer. At the end of the outsourcingcontract, there are there possible scenarios in relation to these assigned staff (Foster,2003):

1. The staff transfers their employment automatically from the outgoing supplier tothe incoming supplier, and this has the effect of removing from the outgoingsupplier all future costs of employment connected with such staff.

2. The outgoing supplier redeploys the staff elsewhere in its business.3. The staff does not transfer their employment from the outgoing supplier, and since

no suitable redeployment opportunities are available, their posts are redundant atthe point of contract termination/expiry. The outgoing supplier will be liable for theredundancy costs unless they are recoverable from the customer under the termsof the outsourcing contract.



Generally, either point 1 or 2 will apply. The difficulty arises where one of the parties doesnot want one of these scenarios to occur but is also unable or unwilling to allow thealternative scenario to be implemented. This situation will normally occur where thecustomer takes the view that it is not in its commercial interests for them to be a transfer.The incoming supplier may have proposed a different way of delivering the service at alower charge on the assumption that not all, or none of, the staff transfer theiremployment. In such a situation, there is no instrument for facilitating the transfer of stafffrom an outgoing to an incoming supplier.For these reasons, the outgoing supplier will probably concentrate its efforts onredeployment of the staff affected, but this will not always be available, particularly wherethe makeup of its work is geographically and technically disparate. When redeploymentis not available for an employee, then when the contract terminates, his/her post isredundant and the outgoing supplier will be responsible for the redundancy payment dueto the employee (Foster, 2003).

Benefits

Evaluating results is a final stage of the Y model. Implementation results are comparedwith needs for change. It is determined to what extent gaps between desired and currentsituation have been closed. This is the beginning of the IS/IT strategy revision process,where a new process through the Y model takes place. Typically, a new IS/IT strategyprocess should take place every other year in business organizations.Let us look at an evaluation example. We assume that the company now has implementedan outsourcing solution. The outsourcing contract may have been implemented toachieve results such as the following:

• Both organizational and market benefits• Move from architecture stage to integration stage• Improved communication and combination of information• Improved business processes• Improved efficiency and effectiveness in value shop activities• Reach knowledge management technology stage III• Enable use of Internet at the level of e-business• Develop supplementary services to take advantage of opportunities• Improve working procedures in accordance with firm vision• Create different product according to market strategy• Create entry barriers according to competitive forces model• Extend the life of products classified as stars• Attract knowledgeable people in the labor market• Move from imitator to competitor according to the knowledge map



As this list illustrates, there may be a variety of reasons for implementing an outsourcingsolution. When we do the evaluation of results, we will evaluate to what extent suchresults have been achieved. But the evaluation should not be limited to such planned,positive effects of a new service provision. The evaluation should investigate all kindsof effects as illustrated in Figure 10.2. All planned, positive effects listed above belongin the upper-left quadrant for planned benefits. Here we evaluate to what extent we haveachieved results in accordance with the IS/IT strategy. However, we will also haveachieved other benefits from outsourcing implementation that we did not think of whenthe IS/IT strategy was developed. These benefits may be just as valuable as the resultsthan we aimed for. Hence, results are both planned and unplanned results.At the other side of Figure 10.2, there are negative effects of implementing the IS/ITstrategy. Some problems were known, and these problems have been dealt with.However, we will also experience new problems from systems implementation that we didnot think of when the IS/IT strategy was developed. These new problems cause anincrease in negative effects from implementing the IS/IT strategy.Evaluating results at this stage 7 of the Y model implies that all effects have to beconsidered, both positive and negative effects, as well as planned and unplanned effects.This total picture of effects is now compared with the original needs for change from stage3 of the Y model. Discrepancies will be identified and have several consequences:

• Learning will occur from evaluating results• Revision of implementation approach may be needed, including outsourcing

strategy• Revision of the IS/IT strategy may be needed• A new IS/IT strategy may be needed

Figure 10.2. Evaluating effects of IS/IT

Positve Negative Effects

Benefits planned

Problems known

Benefits unexpected

Problems unexpected

Planned

Effects

Unplanned



Strategic Risk Behavior

IT outsourcing represents a strategic decision making involving risk. Risk behavior ofclient managers will influence outsourcing decisions, governance decisions, and termi-nation decisions. Risk can be defined as a condition in which decision makers know thepossible consequences of the decisions as well as their associated probabilities. Instrategic management, it is seldom that all consequences and their probabilities areknown. Thus, risk is often used as if it is the same as uncertainty, or unpredictableconsequences and/or probabilities. In this sense, strategic management scholars referto risk as variance in performance beyond the control of decision makers. In recent years,recognition has been growing in the strategy literature that managers conceive of riskonly as downside possibilities. That is, managers are more concerned with negativevariations in performance, not performance variances as a whole. For our purposes here,we define risk broadly as the unpredictability in decision outcomes. Thus, risk takingwould be to consciously undertake tasks that are associated with uncertain conse-quences (Das & Teng, 2001a).Strategic risk behavior constitutes an essential perspective in analyzing strategicbehavior. Broadly defined, strategic risk taking refers to corporate strategic moves thatcause returns to vary, that involve venturing into the unknown, and that may result incorporate ruin. Considering that risk is a problematic aspect in the management ofbusiness organizations, it is important to understand the reasons that lead strategiststo engage in risky decision-making behavior. Extensive research on risk taking carriedout by psychologists over the years has resulted in two competing paradigms concern-ing the attributes of risk-taking behavior—one suggested by the personality psycholo-gists who focus on individual differences in risk-taking behavior, and the other by theexperimental psychologists who deal with risk taking in such terms as subjectiveexpected utility.The view of the personality psychologists focuses on individual differences in risktaking, so that it ascribes risk behavior mostly to the general traits and dispositionaltendencies of decision makers. Scholars have observed that individuals are fairlyconsistent in their attitudes toward risk—some people seem more comfortable with risktaking than others. Based on such stable individual attribute, researchers differentiatedecision makers in terms of their risk propensity—namely, as being either risk avertersor risk seekers. Some researchers also believe that a dispositional risk propensity canhelp explain, to a large extent, the risk behavior of individuals.In contrast, the experimental psychologists challenge the consistency of such disposi-tional traits and argue that situational factors have a greater influence on risk-takingbehavior. Unlike other psychological attributes, the risk propensity of decision makersseems to lack constancy across decision situations. Since this view attempts to under-stand Everyman’s risk-taking behavior, it regards the external stimulus as more impor-tant. Many empirical studies suggest that situational factors such as outcome historyand decision framing are salient in determining the riskiness of strategic decisions.Hence, the view of the experimental psychologists—which treats risk taking as situationcontingent—seems to command substantial support. Since both views have their virtuesand considerable empirical support, efforts have been made to integrate them. These



studies suggest that the dispositional risk propensity interacts with situational factorsin determining risk-taking behavior. In their article, Das and Teng (2001a) present analternative framework for reconciling the two views on the determinants of strategic riskbehavior. Their framework is illustrated in Figure 10.3.Figure 10.3 illustrates the interplay of two factors: risk propensity and decision context.This framework suggests that decision makers will exhibit high-risk behavior in short-range risk horizons, if the decision context is perceived as a loss position (negativecontext). The framework further suggests that decision makers will exhibit low-riskbehavior in short-range risk horizons if the decision context is perceived as a gainposition (positive context). Furthermore, decision makers who are risk averters willexhibit low-risk behavior in long-range risk horizons. Finally, decision makers who arerisk seekers will exhibit high-risk behavior in long-range risk horizons.In another study, Das and Teng (2001b) developed an integrated framework for trust,control, and risk in strategic alliances, as illustrated in Figure 10.4. Trust and control areinextricably interlinked with risk in strategic alliances such as outsourcing relationships.To understand how partner firms can effectively reduce and manage this risk, we needto examine the inter-relationships between trust, control, and risk. Based on thisframework, they developed the following propositions:

1. A firm’s goodwill trust in its partner firm will reduce its perceived relational risk inan alliance, but not it’s perceived performance risk.

2. A firm’s competence trust in its partner firm will reduce its perceived performancerisk in an alliance, but not it’s perceived relational risk.

3. Perceived relational risk in an alliance will be reduced more effectively by behaviorcontrol than by output control.

4. Perceived performance risk in an alliance will be reduced more effectively by outputcontrol than by behavior control.

Figure 10.3. Strategic risk behaviors based on risk propensity, decision context, andrisk horizon (Das & Teng, 2001a)

Short-range Short-range low-risk behavior high-risk behavior Long-range Long-range low-risk behavior low-risk behavior Cell A Cell B Short-range Short-range low-risk behavior high-risk behavior Long-range Long-range high-risk behavior high-risk behavior Cell C Cell D

Decision context Positive Negative

Risk averter

Risk propensity

Risk

seeker



5. Social control in an alliance will reduce both perceived relational risk and perceivedperformance risk.

6. Both output control and behavior control will undermine goodwill trust andcompetence trust in an alliance.

7. Social control will enhance both goodwill trust and competence trust in an alliance.8. Goodwill trust and competence trust will enhance the effectiveness of all control

modes (behavior, output, and social) in an alliance.9. Control levels remaining the same, the lower the acceptable relational risk level, the

higher the needed goodwill trust level in an alliance. Control levels remaining thesame, the lower the acceptable performance risk level, the higher the neededcompetence trust level in an alliance.

10. Goodwill trust remaining the same, the lower the acceptable relational risk level, themore will be the use of behavior control and social control in an alliance. Compe-tence trust remaining the same, the lower the acceptable performance risk level, themore will be the use of output control and social control in an alliance.

Das and Teng (2001b) propose an integrated framework of trust, control, and risk leadingto these ten propositions. Overall, the framework suggests that trust and control are twoseparate routes to risk reduction in alliances. While trust can be seen as a more intrinsicsource for lowering the perception of risk, control may be viewed as a more overt andactive way of reducing risk.

Conclusions

Managing costs successfully requires more than traditional cost accounting. It requiresan understanding of cost-related theories, such as production and transaction econom-

Figure 10.4. Integrated framework of trust, control, and risk in strategic alliances (Das& Teng, 2001b)

6, 7, 8

TRUST Goodwill Trust

Competence Trust

CONTROL Behavior Control Output Control Social Control

RISK PERCEPTION Relational Risk

Performance Risk

1,2,9

6,7,8

3,4,5,10



ics, hidden costs, and contract termination costs. Managing IT outsourcing successfullyimplies that costs are not judged in isolation. Rather, costs are compared to benefits,before judgments on cost level and development occur.

Case Studies: Outsourcing Costs

Due to their financial conditions, Rolls-Royce was looking for a 10% reduction of ITcosts. But, the strategic issues underlying the outsourcing decision were also internalIT capabilities and the need for a change agent. Due to fact that the decision was takena long time ago, and none of the interviewees were involved in the decision-makingprocess, it was difficult to state what criteria were the most important. A large companysuch as Rolls-Royce can (to some extent) generate economies of scale and scopeinternally by reproducing methods of vendors. And thus, defining outsourcing simplyin terms of procurements activities seems not to capture the true strategic discussion ofthe Rolls-Royce IT outsourcing. What Rolls-Royce had done, to the premises ofmanaging IT services from the board perspectives, was to look at its IT spend as a wholeas a percentage of sales, and looked at that in comparison with its competitors. It wasmoving with EDS toward being at least as competitive as the best of competitors in termsof low costs. The two parties were attempting to drive operational costs as low as theycould between them, to open up for new investments spend to the highest possible level.In the SAS–CSC case, it was obvious that IT costs was an important issue. Benchmarkingshowed that costs and efficiency of SIG were far too high. Inquiring the market, biddersshowed that SAS could benefit from economies of scale by outsourcing IT to an externalservice provider. In neoclassical economic theories outsourcing may be regard as thesubstitution of external purchase for internal activities and an initiation of procurementfrom outside suppliers (Gilley & Rasheed, 2000). By selling SIG and buying services back,the outsourcing reduced SAS’s involvement in successive stages of production, andthus the outsourcing might be viewed as vertical disintegration. SAS had estimated aturnover around MSEK 10,000 in the 5-year period of the outsourcing deal. It had gaineda 20% cost reduction, partly taken up front as a share price, and partly through lowerservice prices. SAS had estimated its total IT budget to be decreasing year by year forthe period 2004–2008. For each year in the deal, SAS had committed a level of IT purchasefrom CSC. The committed level could be a composite of different services, defined in theFrame Agreement by service descriptions, levels, and prices, or it could be new projectsand services as well. By the end of each year, all services bought from all the differentlines of business in SAS were counted. If the total level services did not exceed thecommitted level, an additional fee was calculated. There was however several mecha-nisms regulating what were inside the deal and what were outside the deal, and how totransfer service between years.

This long-term deal allows us to significantly take down costs, while benefiting fromvendors’ global expertise. -Client CFO



There is no doubt ABB had a very strong focus on reducing IT costs. They invited thelargest outsourcers in the world to bid for its IT infrastructure. The scope was definedand the goal was to obtain economies of scale. Neoclassical economic theory suggeststhat all IT functions which an external vendor can operate at lower costs than thecompany should be outsourced. Selecting IBM as vendor, ABB would obtain better costperformance of its IT infrastructure. Whatever service IBM provided under the contract,it was committed to provide competitiveness compared to the market. The ABB–IBMcontract contained a basic volume for each of the 10 years. For each year, there was anestimate of the number of users, and with defined decreasing unit prices. By the agreed-upon decrease in unit prices, ABB had already pocketed the cost savings.In every IT outsourcing transactions costs are present in terms of efforts, time, andmoney incurred in searching, creating, negotiation, monitoring, and enforcing servicecontracts between client and vendor. Therefore, transaction costs can erode compara-tive advantages in production costs of vendors. Rolls-Royce had no doubt discoveredthe costs of service and contract management. By outsourcing, Rolls-Royce hadtransferred to EDS almost all resources with IT competencies. What it later realized wasthat it had a problem understanding what the vendor was doing, and what technologyand what costs were reasonable. Business needs were, of course, developing, and theseneeds had consequences on technology and costs. Rolls-Royce contract managersalone were not able to understand and control the development within a complex IT andbusiness environment. And thus, they had to build strong teams around services andprojects, procurement activities, and knowledge about business processes and applica-tions. ABB seemed to be aware of the contractual complexity of its global deal, and it hadgot management team with sourcing expertise locally and globally. Although transac-tions costs were significant, production cost differences seemed to be more influentialin the sourcing decision than transaction cost differences.



Chapter XI

KnowledgeManagement

In an outsourcing relationship, the vendor and its clients need to transfer knowledge ona continuous basis. Relevant approaches to outsourcing relationships from the knowl-edge management literature include intellectual capital management and businessprocess management, as presented in this chapter. According to Quinn (1999), execu-tives increasingly understand that outsourcing for short-term cost cutting does not yieldnearly as much as outsourcing for longer-term knowledge-based system or strategicbenefits such as greater intellectual depth and access, opportunity scanning, innova-tion, reliability, quality, value-added solutions, or worldwide outreach.

Intellectual Capital Management

In an outsourcing relationship, the vendor will need to manage its intellectual capital sothat clients experience efficient and effective knowledge transfers. One of the key authorsin the area of intellectual capital is Sveiby (2001) who developed a knowledge-basedtheory of the firm to guide in strategy formulation. He distinguishes between threefamilies of intangible assets with the outsourcing vendor.The external structure family consists of relationships with customers and suppliers andthe reputation (image) of the firm. Some of these relationships can be converted into legalproperty such as trademarks and brand names. The value of such assets is primarilyinfluenced by how well the company solves its customers’ problems, and there is alwaysan element of uncertainty here. The internal structure family consists of patents,concepts, models, and computer and administrative systems. These are created by theemployees and are thus generally owned by the organization. The structure is partlyindependent of individuals and some of it remains even if a large number of the employees

Knowledge Management 255


leave. The individual competence family consists of the competence of the professionalstaff, the experts, the research and development people, the factory workers, sales andmarketing—in short, all those who have a direct contact with customers and whose workare within the business idea.Competence is a term introduced here. Competence can be defined as the sum ofknowledge, skills, and abilities at the individual level. With this definition, we say thatknowledge is part of competence, and competence is part of intellectual capital. Thesethree families of intangible resources have slightly different definitions when comparedto the capital elements. The external structure seems similar to relational capital; theinternal structure seems similar to structural capital, while the individual competenceseems similar to human capital.To appreciate why a knowledge-based theory of the firm can be useful for strategyformulation, Sveiby (2001) considers some of the features that differentiate knowledgetransfers from tangible goods transfers. In contrast to tangible goods, which tend todepreciate in value when they are used, knowledge grows when used and depreciateswhen not used. Competence in a language or a sport requires huge investments in trainingto build up; managerial competence takes a long time on-the-job to learn. If one stopsspeaking the language it gradually dissipates.Given three families of intangible assets, it is possible to identify nine knowledgetransfers. These knowledge transfers can occur within a family and between families asillustrated in Figure 11.1. Each of the nine knowledge transfers in Figure 10.1 can beexplained as follows (Sveiby, 2001):

Figure 11.1. Knowledge transfer within and between families of intangible assets

Individual Competence

External Structure

Internal Structure

1

2

3

4

5

6

7

8

9



1. Knowledge transfers between individuals concern how to best enable the commu-nication between employees within the organization. The strategic question is,“How can we improve the transfer of competence between people in the organiza-tion?” Activities for intellectual capital management focus on trust building,enabling team activities, induction programs, job rotation, and master/apprenticescheme.

2. Knowledge transfers from individuals to external structure concern how theorganization’s employees transfer their knowledge to the outer world. The strate-gic question is, “How can the organization’s employees improve the competenceof customers, suppliers and other stakeholders?” Activities for intellectual capitalmanagement focus on enabling the employees to help customers learn about theproducts, getting rid of red tape, enabling job rotation with customers, holdingproduct seminars, and providing customer education.

3. Knowledge transfers from external structure to individuals occur when employ-ees learn from customers, suppliers, and community feedback through ideas, newexperiences, and new technical knowledge. The strategic question is, “How can theorganization’s customers, suppliers, and other stakeholders improve the compe-tence of the employees?” Activities for intellectual capital management focus oncreating and maintaining good personal relationships between the organization’sown people and the people outside the organization.

4. Knowledge transfers from competence to internal structure concern the transfor-mation of human capital into more permanent structural capital through docu-mented work routines, intranets, and data repositories. The strategic question is,“How can we improve the conversion individually held competence to systems,tools, and templates?” Activities for intellectual capital management focus ontools, templates, process, and systems so that they can be shared more easily andefficiently.

5. Knowledge transfers from internal structure to individual competence is thecounterpart of the above. Once competence is captured in a system, it needs to bemade available to other individuals in such a way that they improve their capacityto act. The strategic question is, “How can we improve individuals’ competenceby using systems, tools, and templates?” Activities for intellectual capital manage-ment focus on improving human-computer interface of systems, action-basedlearning processes, simulations, and interactive e-learning environments.

6. Knowledge transfers within the external structure concern what customers andothers tell each other about the services of an organization. The strategic questionis, “How can we enable the conversations among the customers, suppliers, andother stakeholders so that they improve their competence?” Activities for intellec-tual capital management focus on partnering and alliances, improving the image ofthe organization and the brand equity of its products and services, improving thequality of the offering, and conducting product seminars and alumni programs.

7. Knowledge transfers from external to internal structure concern what knowledgethe organization can gain from the external world and how the learning can beconverted into action. The strategic question is, “How can competence from thecustomers, suppliers, and other stakeholders improve the organization’s systems,



tools, processes, and products? Activities for intellectual capital managementfocus on empowering call centers to interpret customer complaints, creatingalliances to generate ideas for new products and research and developmentalliances.

8. Knowledge transfers from internal to external structure is the counterpart of theabove. The strategic question is, “How can the organization’s systems, tools,processes, and products improve the competence of the customers, suppliers, andother stakeholders?” Activities for intellectual capital management focus onmaking the organization’s systems, tools, and processes effective in servicing thecustomer, extranets, product tracking, help desks, and e-business.

9. Knowledge transfers within the internal structure where the internal structure isthe backbone of the organization. The strategic question is, “How can theorganization’s systems, tools, processes, and products be effectively integrated?Activities for intellectual capital management focus on streamlining databases,building integrated IT systems and improving the office layout.

The outsourcing promise is to leverage the supplier’s superior technical know-how(human capital), superior management practices (structural capital), economies of scale,and increasingly, access to strategic and business advice. This should enable the clientto refocus on strategic core capability and knowledge areas. But Willcocks, Hindle,Feeny, and Lacity’s (2004) research into IT outsourcing has shown consistently over thepast decade that the prospects have been disappointing for meaningful knowledgemanagement and value creation, therefore,

• Most clients report their frustration from with endless cost-service debates, andsometimes significant loss of control over their IT destiny and knowledge base.

• Most vendors find it difficult to deliver on their promises of innovation and value-added, because of their lack of knowledge about the client’s long-term businessstrategy.

Typically, even on the very big, long-term deals considered to be strategic vendorrelationships, the supplier offers technical know-how for routine solutions, with highperformers in short supply. There is little influx of new technical/managerial talent, anddisappointing access to the supplier’s global capacity and knowledge base. Meanwhile,the client does not thoroughly think through the issues of core capability and retainedknowledge. As a result, the client spends much time fire fighting and experiences littlevalue-added or technical/business innovation. Over time, the client loses control overits IT destiny or business process destiny, as knowledge asymmetries develop in favorof the vendor.The loss of information and knowledge can be traumatic for both outsourcing partiesunless specific and purposeful steps are undertaken to develop and sustain newinformation pathways and capabilities. That is why the nine knowledge transfer mecha-nisms are so important for success. In addition, the client has to retain several corecapabilities. These ensure the elicitation and delivery of business requirements, the



development of technical/business architecture, the managing of external supply, andthe coordination and governance of these tasks. In practice, Willcocks et al. (2004) havefound all too many client organizations inadequately making these critical, initialknowledge investments.The traditional IT outsourcing approach restricts creation and leveraging of knowledgeconcerns only to one specialist area: IT operations. However, much bigger knowledgegains can arise if whole functions or processes that include IT are outsourced. This isthe premise of the dramatic growth in business process outsourcing (BPO). Theknowledge contract of BPO is to outsource IT functions to suppliers that have superiorstructural and human capital in the areas of business process and specific expertise. Somedeals also recognize the need for closer partnering to get closer to the customer: to createand leverage relational capital to both parties’ advantage.

Vendor Value Proposition

Career development, methodology development, and dissemination and client relation-ship management are three core competencies that give customer value, according toLevina and Ross (2003), as discussed in Chapter III. Customer value will increase if thevendor achieves an improvement in career development, methodology development, anddissemination and client relationship management. In a knowledge management perspec-tive, we can argue that more use of knowledge management systems will improve thevendor’s core competencies and thereby lead to higher customer value. In other words,the more extensive use of knowledge management systems by the vendor to support corecompetencies, the more improved core competencies at the vendor for customer value,and the greater the customer value from these core competencies is achieved.Levina and Ross (2003) draw on theories of complementarity in organizational design,core competencies, and client vendor relationship literature. Studies have also foundreasons for IT outsourcing to be more strategic instead of pure tactical and economical,and where the value for the customer is the ability to focus “internal staff on moving usto the environment that will support us tomorrow” by outsourcing routine work andnonstrategic IT operations and processes (DiRomualdo & Gurbaxani, 1998, p. 73).The vendor and the client have to exchange information about each other in anoutsourcing arrangement. The vendor has to develop an understanding of the customer’sbusiness, and the customer has to develop an understanding of the systems the vendorprovides. Levina and Ross (2003) suggest that the vendor creates value for the customerbased on three complementary competencies, where the vendor’s understanding of thecustomer’s business is included.Links between knowledge management systems, core competencies, and customer valueare illustrated in Figure 11.2. The extent of success from knowledge management systemsdepends on user skills, procedures for knowledge management and information re-sources in the systems. The extent of success from competencies depends on thepositive, dynamic interactions between personnel development, methodology develop-ment, and client relationships management.



Finally in Figure 11.2, customer value is created in the interactions and spiral suggestedby Levina and Ross (2003). The spiral says that increased number of projects drives andenables to build and apply vendor’s core competencies, which in turn provides higherlevels of client satisfaction at lower marginal costs, which in turn improves vendorreputation, and which in turn leads to increased number and variety of projects controlledby the vendor.

Business Process Management

In an interorganizational relationship such as outsourcing, business processes includeboth the vendor and the client. These processes may be part of an electronic businessenvironment. In order to get work done, every organization creates and aligns specificsequences of tasks to achieve particular purposes. For example, a substantial number ofrelated tasks must be executed in a specific sequence in order to receive and fulfillcustomers’ orders or to purchase and acquire components from suppliers. When anumber of tasks cumulate to constitute the execution of some substantial organizational(or business) requirement, they are commonly referred to as a business or organizationalprocess.The new business landscape ushered in by e-business has revolutionized businessoperations, but to date, has not integrated well with internal knowledge managementinitiatives. Through the development of e-business focused knowledge, organizationscan accomplish three critical tasks: (1) evaluate what type of work organizations are doingin the e-business environment (know-what); (2) understand how they are doing it (know-how); and (3) determine why certain practices and companies are likely to undergochange for the foreseeable future (know-why). In research conducted by Fahey, Srivastava,Sharon, and Smith (2001), they take a process perspective and reflect upon the value e-business knowledge contributes in the enhancement of three core operating processes:customer relationship management, supply-chain management, and product develop-ment management. Understanding how e-business impacts these core processes and thesubprocesses within them, and then leveraging that knowledge to enhance theseprocesses, can be key to an organization’s success in deriving superior marketplaceresults. In the following, therefore, the central role of knowledge management indiagnosing and managing e-business-driven changes in organizations is highlighted.

Figure 11.2. Knowledge management supporting vendor value proposition in IToutsourcing

Vendor Core Complementary Competencies

Personnel Methods

Relationships

Vendor Knowledge Management Systems

Skills Procedures

Resources

Vendor-Supplied Customer Value

Projects Competencies

Satisfaction



E-business gives rise to fundamental issues for both knowledge stock and flow. Becauseof the extensive impact of e-business on such pivotal business domains as solutions,rivals, strategy, assets, and business processes, organizations have little choice but todevelop, share, and leverage extensive knowledge about e-business. At a macro level,such knowledge management efforts might focus on key current, emerging, and potentialtrends and patterns in e-business and how they affect (or could affect) the firm’scompetitive context, strategy, and all key facets of its operations including assets andoperating processes. E-business-focused knowledge can be systematically delineatedand integrated by distinguishing carefully between the following (Fahey et al., 2001):

• Know-what (i.e., describing current and future e-business change and its implica-tions for strategy, operations, and competitive context)

• Know-how (i.e., what an organization does or must do to adapt and leverage e-business for strategic and operational purposes)

• Know-why (i.e., why e-business is evolving as it is and what accounts for itsimpacts on competitive context, strategy, and operations)

Knowledge Management Technology

IT can play an important role in successful knowledge management initiatives. However,the concept of coding and transmitting knowledge in organizations is not new: trainingand employee development programs, organizational policies, routines, procedures,reports, and manuals have served this function for many years. What is new and excitingin the knowledge management area is the potential for using modern IT (e.g., the Internet,intranets, extranets, browsers, data warehouses, data filters, software agents, expertsystems) to support knowledge creation, sharing, and exchange in an organization andbetween organizations. Modern IT can collect, systematize, structure, store, combine,distribute, and present information of value to knowledge workers.More and more companies have instituted knowledge repositories, supporting suchdiverse types of knowledge as best practice, lessons learned, product developmentknowledge, customer knowledge, human resource management knowledge, and meth-ods-based knowledge. Groupware and intranet-based technologies have become stan-dard knowledge infrastructures. A new set of professional job titles—the knowledgemanager, chief knowledge officer (CKO), knowledge coordinator, and knowledge-network facilitator—affirms the widespread legitimacy that knowledge management hasearned in the corporate world.The low cost of computers and networks has created a potential infrastructure forknowledge sharing and opened up important knowledge management opportunities. Thecomputational power as such has little relevance to knowledge work, but the communi-cation and storage capabilities of networked computers make it an important enabler ofeffective knowledge work. Through e-mail, groupware, the Internet, and intranets,computers and networks can point to people with knowledge and connect people who



need to share knowledge independent of time and place. Distinctions are often madebetween data, information, knowledge, and wisdom:

• Data are letters and numbers without meaning. Data are independent, isolatedmeasurements, characters, numerical characters, and symbols.

• Information is data that are included in a context that makes sense. For example,40 degrees can have different meaning depending on the context. There can be amedical, geographical, or technical context. If a person has a 40 degrees Celsiusfever, that is quite serious. If a city is located 40 degrees north, we know that it isfar south of Norway. If an angle is 40 degrees, we know what it looks like.Information is data that make sense, because it can be understood correctly. Peopleturn data into information by organizing them into some unit of analysis, forexample, dollars, dates, or customers. Information is data endowed with relevanceand purpose.

• Knowledge is information combined with experience, context, interpretation, andreflection. Knowledge is a renewable resource that can be used over and over, andthat accumulates in an organization through use and combination with employees’experience. Humans have knowledge; knowledge cannot exist outside the headsof individuals in the company. Information becomes knowledge when it enters thehuman brain. This knowledge transforms into information again when it is articu-lated and communicated to others. Information is an explicit representation ofknowledge; it is in itself not knowledge. Knowledge can be both truths and lies,perspectives and concepts, judgments and expectations. Knowledge is used toreceive information by analyzing, understanding, and evaluating; by combining,prioritizing, and decision making; and by planning, implementing, and controlling.

• Wisdom is knowledge combined with learning, insights, and judgmental abilities.Wisdom is more difficult to explain than knowledge, since the levels of contextbecome even more personal, and thus the higher-level nature of wisdom rendersit more obscure than knowledge. While knowledge is mainly sufficiently general-ized solutions, wisdom is best thought of as sufficiently generalized approachesand values that can be applied in numerous and varied situations. Wisdom cannotbe created like data and information, and it cannot be shared with others likeknowledge. Because the context is so personal, it becomes almost exclusive to ourown minds and incompatible with the minds of others without extensive transac-tion. This transaction requires not only a base of knowledge and opportunities forexperiences that help create wisdom, but also the processes of introspection,retrospection, interpretation, and contemplation. We can value wisdom in others,but we can only create it ourselves.

Regardless of definition of knowledge as the highest value of content in a continuumstarting at data, encompassing information, and ending at knowledge, knowledgemanagers often take a highly inclusive approach to the content with which they deal. Inpractice, what companies actually manage under the banner of knowledge managementis a mix of knowledge, information, and unrefined data—in short, whatever anyone findsthat is useful and easy to store in an electronic repository. In the case of data and



information, however, there are often attempts to add more value and create knowledge.This transformation might involve the addition of insight, experience, context, interpre-tation, or the myriad of other activities in which human brains specialize (Grover &Davenport, 2001).Identifying, nurturing, and harvesting knowledge is a principal concern in the informa-tion society and the knowledge age. Effective use of knowledge-facilitating tools andtechniques is critical, and a number of computational tools have been developed. Whilenumerous techniques are available, it remains difficult to analyze or compare the specifictools. In part, this is because knowledge management is a young discipline. The arenais evolving rapidly as more people enter the fray and encounter new problems.In addition, new technologies support applications that were impossible before. More-over, the multidisciplinary character of knowledge management combines several disci-plines, including business and management, computer science, cybernetics, and phi-losophy. Each of these fields may lay claim to the study of knowledge management, andthe field is frequently defined so broadly that anything can be incorporated. Finally, itis difficult to make sense of the many tools available. It is not difficult to perform a searchto produce a list of more than 100 software providers. Each of the software packagesemploy unique visions and aims to capture its share of the market.Ward and Peppard (2002) find that there are two dominant and contrasting views of IS/IT in knowledge management: the engineering perspective and the social processperspective. The engineering perspective views knowledge management as a technol-ogy process. Many organizations have taken this approach in managing knowledge,believing that it is concerned with managing pieces of intellectual capital. Driving thisview is the view that knowledge can be codified and stored; in essence that knowledgeis explicit knowledge and therefore is little more than information.The alternative view is that knowledge is a social process. As such, it asserts thatknowledge resides in people’s heads and that it is tacit. It cannot be easily codified andonly revealed through its application. As tacit knowledge cannot be directly transferredfrom person to person, its acquisition occurs only through practice. Consequently, itstransfer between people is slow, costly, and uncertain. Technology, within this perspec-tive, can only support the context of knowledge work. IT-based systems used to supportknowledge management might only be of benefit if used to support the development andcommunication of human meaning. One reason for the failure of IT in some knowledgemanagement initiatives is that the designers of the knowledge management systems failto understand the situation and work practices of the users and the complex humanprocesses involved in work. While technology can be used with knowledge managementinitiatives, Ward and Peppard (2002) argue that it should never be the first step.Knowledge management is to them primarily a human and process issue. Once these twoaspects have been addressed, then the created processes are usually very amenable tobeing supported and enhanced by the use of technology.What, then, is knowledge management technology? According to Davenport and Prusak(1998), the concept of knowledge management technology is not only broad but also abit slippery to define. Some infrastructure technology that we don’t ordinarily think ofin this category can be useful in facilitating knowledge management. Examples arevideoconferencing and the telephone. Both of these technologies do not capture or



distribute structured knowledge, but they are quite effective at enabling people totransfer tacit knowledge.Our focus here, however, is on technology that captures, stores, and distributesstructured knowledge for use by people. The goal of these technologies is to takeknowledge that exists in human heads and partly in paper documents, and make it widelyavailable throughout an organization. Similarly, Alavi and Leidner (2001) argue that ISdesigned to support knowledge in organizations may not appear radically different fromother forms of IT support, but will be geared toward enabling users to assign meaningto information and to capture some of their knowledge in information. Therefore, theconcept of knowledge management technology in this book is less concerned with anydegree of technology sophistication and more concerned with the usefulness in perform-ing knowledge work in organizations and between organizations.Moffett and McAdam (2003) illustrate the variety of knowledge management technologytools by distinguishing between collaborative tools, content management, and businessintelligence. Collaborative tools include groupware technology, meeting support sys-tems, knowledge directories, and intranets/extranets. Content management includes theInternet, agents and filters, e-publishing systems, document management systems, andoffice automation systems. Business intelligence includes data warehousing, decisionsupport systems, knowledge-based systems, and workflow systems.

Stages of Technology Growth

Stages of knowledge management technology (KMT) is a relative concept concernedwith IT’s ability to process information for knowledge work. IT at later stages is moreuseful to knowledge work than IT at earlier stages. The relative concept implies that ITis more directly involved in knowledge work at higher stages, and that IT is able tosupport more advanced knowledge work at higher stages.The KMT stage model consists of four stages (Gottschalk, 2005). The first stage isgeneral IT support for knowledge workers. This includes word processing, spread-sheets, and e-mail. The second stage is information about knowledge sources. An ISstores information about who knows what within the firm and outside the firm. The systemdoes not store what they actually know. A typical example is the company intranet. Thethird stage is information representing knowledge. The system stores what knowledgeworkers know in terms of information. A typical example is a database. The fourth andfinal stage is information processing. An IS uses information to evaluate situations. Atypical example here is an expert system.The contingent approach to firm performance implies that Stage I may be right for onefirm, while Stage IV may be right for another firm. Some firms will evolve over time fromStage I to higher stages as indicated in Figure 11.3. The time axis ranging from 1990 to2020 in Figure 11.3 suggests that it takes time for an individual firm and a whole industryto move through all stages. As an example applied later in this chapter, the law firmindustry is moving slowly in its use of IT. Stages of IT support in knowledge management



are useful for identifying the current situation as well as planning for future applicationsin the firm. Each stage is described below.

Stage I

Tools for end users are made available to knowledge workers. In the simplest stage, thismeans a network-capable PC on every desk or in every briefcase, with standardizedpersonal productivity tools (word processing, presentation software, e-mail) so thatdocuments can be exchanged easily throughout a company. More complex and func-tional desktop infrastructures can also be the basis for the same types of knowledgesupport. Stage I is recognized by widespread dissemination and use of end-user toolsamong knowledge workers in the company. For example, lawyers in a law firm will in thisstage use word processing, spreadsheets, legal databases, presentation software, andscheduling programs. Stage I can be labeled end-user tools or people-to-technology asIT provides knowledge workers with tools that improve personal efficiency.

Stage II

Information about who knows what is made available to all people in the firm and to selectoutside partners. Search engines should enable work with a thesaurus, since theterminology in which expertise is sought may not always match the terms the expert usesto classify that expertise. According to Alavi and Leidner (2001), the creation of corporatedirectories, also referred to as the mapping of internal expertise, is a common applicationof knowledge management technology. Because much knowledge in an organizationremains uncodified, mapping the internal expertise is a potentially useful application oftechnology to enable easy identification of knowledgeable persons.Here we find the cartographic school of knowledge management, which is concerned withmapping organizational knowledge. It aims to record and disclose who in the organizationknows what by building knowledge directories. Often called Yellow Pages, the principal

Figure 11.3. The knowledge management technology stage model Stages of Growth for Knowledge Management Technology Stage IV HOW THEY THINK Stage III WHAT THEY KNOW Stage II WHO KNOWS WHAT Stage I END-USER TOOLS

1990 2000 2010 2020



idea is to make sure knowledgeable people in the organization are accessible to othersfor advice, consultation, or knowledge exchange. Knowledge-oriented directories arenot so much repositories of knowledge-based information as gateways to knowledge,and the knowledge is as likely to be tacit as explicit.Information about who knows what is sometimes called metadata, representing knowl-edge about where the knowledge resides. Providing taxonomies or organizationalknowledge maps enables individuals to rapidly locate the individual who has the neededknowledge, more rapidly than would be possible without such IT-based support. Onestarting approach in Stage II is to store curriculum vitae (CV) for each knowledge workerin the firm. Areas of expertise, projects completed, and clients helped may over timeexpand the CV. For example, a lawyer in a law firm works on cases for clients using differentinformation sources that can be registered on Yellow Pages in terms of an intranet. AtStage II, firms apply the personalization strategy in knowledge management. Thepersonalization strategy implies that knowledge is tied to the person who developed itand is shared mainly through direct person-to-person contact. This strategy focuses ondialogue between individuals: knowledge is transferred mainly in personal e-mail,meetings, and one-on-one conversations.The creation of a knowledge network is an important part of Stage II. Unless specialistscan communicate easily with each other across platform types, expertise will deteriorate.People have to be brought together both virtually and face-to-face to exchange and buildtheir collective knowledge in each of the specialty areas. The knowledge managementeffort is focused on bringing the experts together so that important knowledge can beshared and amplified, rather than on mapping expertise or benchmarking which occursin Stage III. The knowledge network is built on modern communication technology.Advance in portable computers such as palmtops and laptops, in conjunction withwireless network technologies has engendered mobile computing. In mobile computingenvironment, users carrying portable computers are permitted to access the sharedcomputing resources on the network through wireless channel regardless of theirphysical locations.Knowledge directories represent more of a belief in personalized knowledge of individu-als than the codified knowledge of knowledge bases and may demonstrate organizationalpreferences for human, not technology-mediated, communication and exchange. Theknowledge philosophy of firms that settle in Stage II can be seen as one of peopleconnectivity. Consequently, the principal contribution from IT is to connect people viaintranets and to help them locate knowledge sources and providers using directoriesaccessed by the intranet. Extranets and the Internet may connect knowledge workers toexternal knowledge sources and providers.Stage II can be labeled “who-knows-what” or “people-to-people” as knowledge workersuse IT to find other knowledge workers.

Stage III

Information from knowledge workers is stored and made available to everyone in the firmand to designate external partners. Data mining techniques can be applied here to find



relevant information and combine information in data warehouses. On a broader basis,search engines are Web browsers and server software that operate with a thesaurus,since the terminology in which expertise is sought may not always match the terms usedby the expert to classify that expertise. One starting approach in Stage III is to storeproject reports, notes, recommendations, and letters from each knowledge worker in thefirm. Over time, this material will grow quickly, making it necessary for a librarian or a chiefknowledge officer (CKO) to organize it. In a law firm, all client cases will be classified andstored in databases using software such as Lotus Notes. An essential contribution thatIT can make is the provision of shared databases across tasks, levels, entities, andgeographies to all knowledge workers throughout a process.According to Alavi and Leidner (2001), one survey found that 74% of respondentsbelieve that their organization’s best knowledge was inaccessible and 68% think thatmistakes occurred several times. Such a perception of failure to apply existing knowledgeis an incentive for mapping, codifying, and storing information derived from internalexpertise. One of the most common applications is internal benchmarking with the aimof transferring internal best practices. To be successful, best practices have to be coded,stored, and shared among knowledge workers.In addition to best practices knowledge within a quality or business process managementfunction, other common applications include (1) knowledge for sales purposes involvingproducts, markets, and customers, (2) lessons learned in projects or product develop-ment efforts, (3) knowledge around implementation of IS, (4) competitive intelligence forstrategy and planning functions, and (5) learning histories or records of experience witha new corporate direction or approach (Grover & Davenport, 2001).In Stage III, access both to knowledge (expertise, experience, and learning) and toinformation (intelligence, feedback, and data analyses) is provided by systems andintranets to operatives, staff, and executives. The supply and distribution of knowledgeand information are not restricted. Whereas we might say in Stage I, “Give knowledgeworkers the tools to do the job,” we now add, “Give knowledge workers the knowledgeand information to do the job.” This is another way of saying that the philosophy isenhancing the firm’s capabilities with knowledge flows.Although most knowledge repositories serve a single function, Grover and Davenport(2001) find that it is increasingly common for companies to construct an internal portalso that employees can access multiple different repositories and sources from onescreen. It is also possible and increasingly popular for repositories to contain informationas well as pointers to experts within the organization on key knowledge topics. Oftencalled Knowledge Yellow Pages, these systems facilitate contact and knowledge transferbetween knowledgeable people and those who seek their knowledge. Stored, codifiedknowledge is combined with lists of individuals who contributed the knowledge andcould provide more detail or background on it.In Stage III, firms apply the codification strategy in knowledge management. Thecodification strategy centers on IT: knowledge is carefully codified and stored inknowledge databases and can be accessed and used by anyone. With a codificationstrategy, knowledge is extracted from the person who developed it, is made independentfrom the person and stored in form of interview guides, work schedules, benchmark data,and so forth, and then searched and retrieved and used by many employees.



According to Grover and Davenport (2001), firms increasingly view attempts to transformraw data into usable knowledge as part of their knowledge management initiatives. Theseapproaches typically involve isolating data in a separate warehouse for easier access andthe use of statistical analysis or data mining and visualization tools. Since their goal isto create data-derived knowledge, they are increasingly addressed as part of knowledgemanagement in Stage III.Stage III can be labeled “what-they-know” or “people-to-docs” as IT provides knowl-edge workers with access to information that is typically stored in documents. Examplesof documents are contracts and agreements, reports, manuals and handbooks, businessforms, letters, memos, articles, drawings, blueprints, photographs, e-mail and voice mailmessages, video clips, script and visuals from presentations, policy statements, com-puter printouts, and transcripts from meetings.Concepts and ideas contained in documents are often far more valuable and importantto organizations than facts traditionally organized into data records. A document can bedescribed as a unit of recorded information structured for human consumption. It isrecorded and stored, so a speech or conversation for which no transcript is prepared isnot a document. A document is a snapshot of some set of information that can incorporatemany complex information types, exist in multiple places across a network, depend onother documents for information, change as subordinate documents are updated, and beaccessed and modified by many people simultaneously.

Stage IV

IS solving knowledge problems are made available to knowledge workers and solutionseekers. Artificial intelligence is applied in these systems. For example, neural networksare statistically oriented tools that excel at using data to classify cases into one categoryor another. Another example is expert systems that can enable the knowledge of one ormore experts to be used by a much broader group of workers requiring the knowledge.According to Alavi and Leidner (2001), an insurance company was faced with thecommoditization of its market and declining profits. The company found that applyingthe best decision-making expertise via a new underwriting process, supported by aknowledge management system based on best practices, enabled it to move intoprofitable niche markets and, hence, to increase income.According to Grover and Davenport (2001), artificial intelligence is applied in rule-basedsystems, and more commonly, case-based systems are used to capture and provideaccess to resolutions of customer service problems, legal knowledge, new productdevelopment knowledge, and many other types of knowledge.Knowledge is explicated and formalized during the knowledge codification phase thattook place in Stage III. Codification of tacit knowledge is facilitated by mechanisms thatformalize and embed it in documents, software, and systems. However, the higher thetacit elements of the knowledge, the more difficult it is to codify. Codification of complexknowledge frequently relies on IT. Expert systems, decision support systems, documentmanagement systems, search engines, and relational database tools represent some ofthe technological solutions developed to support this phase of knowledge management.



Consequently, advanced codification of knowledge emerges in Stage IV, rather than inStage III, because expert systems and other artificial intelligence systems have to beapplied to be successful.Stage IV can be labeled “how-they-think” or “people-to-systems” where the system isintended to help solve a knowledge problem.

Examples of IS/IT

When companies want to use knowledge in real-time, mission-critical applications, theyhave to structure the information base for rapid, precise access. A Web search yieldinghundreds of documents will not suffice when a customer is waiting on the phone for ananswer. Representing and structuring knowledge is a requirement that has long beenaddressed by artificial intelligence researchers in the form of expert systems and otherapplications. Now their technologies are being applied within the context of knowledgemanagement. Rule-based systems and case-based systems are used to capture andprovide access to customer service problem resolution, legal knowledge, new productdevelopment knowledge, and many other types of knowledge. Although it can bedifficult and labor-intensive to author a structured knowledge base, the effort can payoff in terms of faster responses to customers, lower cost per knowledge transaction, anddecreased requirements for experienced, expert personnel (Grover & Davenport, 2001).Expert systems are in Stage IV in the proposed model. Stewart (1997) argues for Stage II,stating that knowledge grows so fast that any attempt to codify all is ridiculous; but theidentities of in-house experts change slowly. Corporate Yellow Pages should be easy toconstruct, but it is remarkable how few companies have actually done this. A simplesystem that connects inquirers to experts saves time, reduces error and guesswork, andprevents the reinvention of countless wheels.What may be stored in Stage III, according to Stewart (1997), are lessons learned andcompetitor intelligence. A key way to improve knowledge management is to bank lessonslearned—in effect, prepare checklists of what went right and wrong, together withguidelines for others undertaking similar projects. In the area of competitor intelligence,companies need to organize knowledge about their suppliers, customers, and competi-tors.IT can be applied at four different levels to support knowledge management in anorganization, according to the proposed Stages of Growth. At the first level, end-usertools are made available to knowledge workers. At the second level, information on whoknows what is made available electronically. At the third level, some informationrepresenting knowledge is stored and made available electronically. At the fourth level,IS capable of simulating human thinking are applied in the organization. These four levelsare illustrated in Figure 11.4, where they are combined with knowledge management tasks.The entries in the figure only serve as examples of current systems.One reason for Stage III emerging after Stage II is the personalization strategy versus thecodification strategy. The individual barriers are significantly lower with the personal-ization strategy, because the individual professional maintains the control through thewhole knowledge management cycle.



Knowledge management strategies focusing on personalization could be called commu-nication strategies, because the main objective is to foster personal communicationbetween people. Core IT systems with this strategy are Yellow Pages (directories ofexperts, who-knows-what systems, people finder database) that show inquirers whomthey should talk to regarding a given topic or problem. The main disadvantages ofpersonalization strategies are a lack of standards and the high dependence on commu-nication skills and the will of the professionals. Such disadvantages make firms want toadvance to Stage III. In Stage III, independence in time among knowledge suppliers andknowledge users is achieved.

Conclusions

Managing successful IT outsourcing relationships requires a steady flow of knowledgebetween vendor and customer. The client transfers knowledge on user performance andrequirements, while the vendor transfers knowledge on system performance and solu-tions. Both exchange knowledge to develop new knowledge. Know-what, know-how,and know-why are important categories in this exchange. IT support in knowledgemanagement should be installed quickly, following the stages of growth model.

Case Studies: Retained Skills

When the initial outsourcing took place, Rolls-Royce kept very few skills in-house. Itrealized that was unhelpful, because it created naïveté on Rolls-Royce’s side and it

Figure 11.4. Examples of IS/IT in different knowledge management stages

STAGES

TASKS

I END-USER TOOLS

People-to-technology

II WHO KNOWS WHAT

People-to-people

III WHAT THEY KNOW

People-to-docs

IV WHAT THEY THINK People-to-systems

Distribute knowledge

Word Processing Desktop Publishing

Web Publishing Electronic Calendars

Presentations



Presentations



Presentations



Presentations Share

knowledge Groupware

Intranets Networks

E-mail

Groupware Intranets Networks

E-mail

Groupware Intranets Networks

E-mail Capture

knowledge Databases

Data Warehouses Databases

Data Warehouses Apply

knowledge Expert Systems

Neural Networks Intelligent Agents



created a degree of frustration on the outsourcer side. Rolls-Royce had to rebuild a teamwith very experienced IT outsourcing managers. Team was built around managing theservices and the projects, and managing the procurement activities. Rolls-Royce foundthat the best way to arrive at a strong relationship with the outsourcer was to have peoplewho deeply understood the business. Meaning, to be an intelligent buyer, you need tounderstand your own business. The outsourcer could not give all business and ITstrategies. Where Rolls-Royce wanted to be in five years’ time, that was its business.Rolls-Royce realized that it needed to keep knowledge about the business processes (theapplications) and how it was built up, which included the architecture. It had to rebuildthat knowledge in-house: overall architecture skills, solution architecture skill, contractmanagement skills, strategic management skills, and skills to manage top-down gover-nance.

Failure to set up retained IT management is probably the key success crusher. We havea lot of problems with it, and the outsourcer does not feel that it is on its span ofinfluence, because you cannot yet tell the client how you should be managed. It requiresa lot of trust to do that. -Senior account manager

The top management decision of SAS was to sell SIG, and not to touch other ITcommunities in the SAS Group. In this way, the transfer of SIG could be handled cleanand fast. Corporate IT, the CIO’s staff, were a small people. They had gradually builtmanagement capacity, contract management, and service-level management. They hadthe responsibility for the Frame Agreements with SIG for several years, being moreprofessional and market oriented year by year. SAS kept around 300 IT employees in SASairlines, ground handling, and technical services. As an example, the common functionairline IT was a competence center focusing on airline business applications. It had thenecessary resources to manage and follow up services, analyze new requirements, andto purchase from CSC. The airline IT organization had more than 100 employees. Thesekinds of common functions might not be very numerous in the future. As the vendororganization was expected to be more professional, SAS would continue to profession-alize itself as a buyer of business application services.The ABB countries were responsible for the agreements themselves, and they hadresponsibility for operations management, contract management, and, of course, theirbusiness applications, which were not outsourced. ABB kept in-house senior sourcingmanagers to follow up on the commercial and economic sides of the deal, and it also keptoperational managers to following up on service levels. Globally, there was a small groupof people handling the global deal.

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Chapter XII

Exit Strategy

Outsourcing contracts do not last forever. And sooner or later, the client has to think of“where to go by the end of this contract?” and “how to get there?” Resources arenecessary no matter if the decision is renegotiating with current supplier, changingsupplier, or bringing IT home. Sometimes, unexpected events occur, and these needsrequire resources as well.

Think Exit

“Avoid future trouble: think exit with outsourcing contracts,” argues Supplier Selection(2003). As purchasing professionals become more involved in the process of outsourcinginitiatives, they face the growing pressure to enact contracts that should be as completeas possible for the type of outsourcing relationship undertaken. A key part of beingcomplete is a provision for an early exit or termination. Purchasing professionals, whennegotiating an outsourcing contract, should leave some maneuvering room in the eventthe relationship does not work out as planned. Negotiation experts suggest putting exitclauses in contracts and for companies to consider backup options for the most criticalcomponents and capabilities. Every outsourcing contract needs provisions for thenormal expiration of the contract and provisions for premature termination. Accordingto Supplier Selection (2003), the failure rate for third-party partnerships is as high as 55%within five years. Of those that do continue to remain in a partnership arrangement, 12%report being unhappy and regret ever making the deal. To avoid future trouble, thinkingexit with outsourcing contracts may include the following:



• Agree on a back-out plan. The outsourcer has no incentive to support switchingbecause the revenue stream is going away. Therefore, a back-out plan shoulddefine sourcing responsibilities in providing the required planning information andthe operational support during a transition.

• Define communication between outsourcing vendors during transition. Coordi-nating the switchover will require the cooperation of the previous outsourcingsupplier. Communication and coordination responsibilities need to be clearlydefined between all parties (the prior outsourcer, the successor outsourcer, and theinternal operation group affected).

• Avoid outsourcer bankruptcy. In a bankruptcy, the supplier should not have theright to assume your contract if the supplier finds it to be beneficial, or to reject itif the supplier finds it to be burdensome. The supplier should have no right basedon an executory contract, meaning there are material ongoing performance obliga-tions under the contract as of the bankruptcy filing. Also, if the supplier does notwant to make a quick decision on assumption or rejection of the contract, it shouldnot be allowed to delay the decision until the end of the case, which can takeanywhere from a few months to several years. During this time, the company couldbe automatically prohibited from unilaterally terminating the contract or otherwiseenforcing remedies under it. If there is no avoidance regulation in the contract, thecustomer will have to continue obtaining the outsourced services and paying thesupplier under the terms of the contract. Obtaining court approval allowing thecustomer to terminate requires that the customer convince the court that thesupplier is currently not performing and is likely to be unable to do so in the future.Implementing the appropriate protective measures can make the difference be-tween being in control of sourcing options, and being a victim of them. There aresome contractual protections that can be employed to help limit exposure. First,financial covenants and current financial information on supplier health can beobtained. Second, prebankruptcy and bankruptcy-proof rights and remedies canbe obtained. Third, customer exposure to subcontractors can be limited. Fourth,ownership and control of software, equipment, data, deliverables, and work inprogress can be retained. Fifth, the assignment of the contract or delegation of thesupplier’s responsibilities can be prohibited. Finally, the customer should makesure the supplier has corresponding protections with respect to its subcontractors.

• Consider a progressive approach to negotiating an outsourcing agreement. Toreduce the incidence of failure, it is suggested that the outsourcing client andvendor put off the drafting of a formal contract agreement until at least 6 months’experience in the business has been accumulated. During the trial, both sidesreview cost structures, service levels and customer needs they describe. Thiseliminates two potential areas of failure. First, the outsourcer does not oversell theircapabilities and promise unrealistic goals in terms of start-up times and the timeframe to bring an operation up to the desired level. Second, it prevents the buyerfrom withholding information it believes might increase the cost of the service.

Bottom line from Supplier Selection (2003) is that outsourcing companies should takeprecautions at the start of the relationship to limit exposure, and then monitor thesupplier’s health to take action before a problem such as bankruptcy filing occurs.

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While things are going well, parties to a contract rarely bother to pull it from the filingcabinet. The problem with outsourcing is that the process all too frequently does gowrong and then it is the legal small print that really matters. In a survey presented byCorporate Finance (2002), it was found that 25% of all outsourcing deals failed, and thatthe failure rate on outsourcing deals now is rising to 50%. A key question is who picksup the bill when things begin to go wrong. The solution is increasingly liability insurance.

Strategic Outsourcing Termination

Termination of an IT outsourcing arrangement involves strategic decision making.General studies of strategic decision making show how rapidly strategic decisions aremade in small firms operating within high-velocity environments, and how decisionspeed is linked to performance. Fast decision makers use more, not less, information thando slow decision makers. The former also develop more, not fewer, alternatives, and usea two-tiered advice process. Conflict resolution and integration between strategicmanagers are also critical to the pace of decision making. Finally, fast decisions basedon this pattern of behaviors lead to superior performance (Elter, 2004).Managers are engaged in myriads of day-to-day activities in attempting to resolvevarious strategic and organization issues associated with internal and external uncer-tainty. Problems and opportunities appear unstructured and incoherent. This makes itdifficult for them to define appropriate and coherent means to address the many pressingbusiness issues. Individuals cannot absorb all the information needed to formulate acomplete set of alternatives from which to choose. Information may not be available andevaluation may be subject to personal biases. This means that actors’ rationality is boundby the environment in which they operate and their own human limitations. Under suchcomplex and uncertain conditions, typically the case in an IT outsourcing terminationsituation, strategic plans become of limited value.Researchers increasingly call for a need to explore the detailed processes and practices,which constitute strategic decision making. Understanding strategizing is a key.Strategizing refers to the continuous formation and transformation of strategic patternsthrough ongoing and intertwined processes of strategic thinking and strategic acting,with several actors involved, on different layers of the organization. IT outsourcingtermination is a strategic issue. The term strategic issue refers to developments or trendsthat emerge from an organization’s internal or external environments recognized bystrategic managers as trends or events with significant influence on an organization’sprospect of reaching a desired future. Strategic issues can be seen as the problems thatactors in an organization engage in getting resolved (Elter, 2004).In strategic outsourcing termination, there are typically three alternatives: (1) continu-ation after termination, (2) continuation with a new service provider after termination, or(3) insourcing after termination. The decision will be influenced by several factors, suchas economic concerns, change in business needs, and service quality concerns. Forexample, the following propositions can be made concerning strategic choices.



• Proposition 1: Economic concerns influence termination strategy. If costs in thecurrent outsourcing arrangement exceed acceptable cost level, then alternative (2)may be preferred over alternative (1), which will be ranked before alternative (3).This would imply that the client has lost faith in the current vendor in terms of thevendor’s ability to cut costs. An alternative vendor may be able to cut costs.

• Proposition 2: Change in business needs influence termination strategy. If thereis a considerable change in business needs that cause the current IS/IT situationto be obsolete and mainly consist of legacy systems, then alternative (1) may beranked first, alternative (3) second, and alternative (2) third. This would imply abelief that major changes in the IS/IT portfolio can either be handled in-house orby the current vendor who knows and understands the client’s business andbusiness needs.

• Proposition 3: Service quality influences termination strategy. If the currentvendor has been unable to provide a service according to the service-levelagreement, then the client can accept the lower quality, but at a lower price, whichwould be choice of alternative (1). However, it is more likely that the client wantsand needs the required service level, causing the client to prefer alternatives (2) and(3) over (1).

Contract Termination

Outsourcing services agreements almost inevitably contain provisions that are to applyon termination, but often neglect to think backward from the point of termination to thedecision the company has to take about whether to terminate. If the company is unableto assess whether there are any realistic alternatives to the provider, it may be forcedeither to renew the existing contract or to put up with substandard services. Althoughdisentangling an outsourcing is a complex process, the company must at least have theoption to do so, even if only to use it as a threat to force a renegotiation. Similarly, if thecompany cannot realistically go to the market with a proposition to alternative serviceproviders, it will not receive any interest, let alone bids. Service providers do not like tobe used as stalking horses against a sitting incumbent without a realistic prospect ofwinning the business—the cost and effort of making a bid are prohibitive (Graham, 2003).All this means that the issue of termination at the end of an agreed term must be dealtwith long before the company presses the button to terminate the services agreement.The company must be able to find out if there are alternatives in the market and the likelycost of moving so that it can decide whether to proceed. The company must be able togive alternative service providers all the same information about the existing operationand services as applied on the initial outsourcing, at least where the new provider is tobe expected to inherit the assets and services. The keys to this are timing and information.If a typical outsourcing takes a year to negotiate, there is little point in the companystarting the retendering process a month before the existing contract is to end.Contract termination does not only occur at the end of an agreed term. In addition, as withmost contracts, an outsourcing agreement will have two principal triggers for termina-

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tion: material breach and the financial difficulties of the other party. The usual trigger fortermination for breach is that the breach must be material and either irremediable or notremedied within a specified period. In order to avoid disputes, the company shouldconsider setting out a nonexhaustive list of breaches that are agreed to be material. Oneway of doing this is to link the clause to the service levels and provide that a certain levelof failure or aggregate amount of service credits will amount to a material breach.The usual trigger for financial difficulties is when the service provider is going intoliquidation or suffering similar problems. A termination clause that only allows fortermination (or the exercise of step-in rights) when the provider is already out of businesswill be too late in the context of service provision, and it should also include events thatmay indicate forthcoming problems, such as a major disposal or refinancing or a reductionin credit rating.In a long-term deal, the company may want the ability to break the agreement prior to theend of the agreed term. Generally, the provider’s own revenue profile will lead to itrefusing to allow such a termination within the first year or so of the start of the agreement.Any termination thereafter, before the end of the agreed term, will lead to the paymentby the customer of a termination charge. This should be less than the charges would havebeen for the remainder of the term (or there is no point in terminating), but the providerwill seek to recover its unamortized costs and lost profits, either as a pre-agreed sum or(more likely) by way of a calculation carried out at the time. The customer needs tounderstand the provider’s cost model to work out the extent to which the charges orcalculation are justified (Graham, 2003).If the provider is taken over by another company, the user may wish to terminate or atleast to threaten to do so, in order to receive some reassurance. The provider will(rightfully) not see this as being a breach of contract at all and resist its inclusion. Acompromise may be to allow termination if the provider is taken over by a competitor ofthe customer (Graham, 2003). The example below of Halifax Bank of Scotland shows howrapid and comprehensive structural changes can affect outsourcing relationships. In thisexample a long-term outsourcing contract is not flexible enough to survive a mergerbetween two large U.K. banks. The vendor could not be blamed and the customer hasto compensate for the termination.

The decision by Halifax Bank of Scotland to terminate a £700m, 10-year outsourcingcontract with IBM after less than two years has already re-ignited the argument overwhether these deals allow for sufficient contract flexibility.A spokesman for HBoS, formed by the merger last year between Bank of Scotland andHalifax bank, claimed the decision to scrap the contract was “all about cost savings”and was part of a wider review of IT cost savings.Despite this rosy picture, the suspicion remains that the failed contract was not flexibleenough to accommodate the changing needs of its original customer, Bank of Scotland.When Bank of Scotland signed the 10-year outsourcing contract with IBM in the summerof 2000 it was hailed as a groundbreaking deal for IT-outsourcing by analysts, and thebank boasted that it would save £150m in IT costs over the lifetime of the contract.



Fast-forward about a year, and the Bank of Scotland announces that it is in merger talkswith Halifax. One year later and the supposed watertight rationale for the deal hasevaporated.Now the bank faces the likelihood of having to pay millions of pounds in penalty clausesto compensate IBM for the abrupt end of the deal. . . .So how can IT managers avoid such deals becoming a burden? A “get-out” clauseallowing for the relatively easy termination of an outsourcing contract is one option,but legal experts warn that companies will have to pay their supplier more money toget this.Mega outsourcing deals have yet to deliver, and have so far proved as unreliable asan English summer. (Computer Weekly, 8/29/2002)

If the user requires that the provider has a certain accreditation or license or approval(e.g., a telecom license or financial services accreditation) and this is lost and notreplaced, the customer may again want to have a right to terminate. There may be eventsthat are particular to the contract or the parties to it that should be included. Thetermination clause should allow the user as much flexibility as possible. It may allow forpartial termination, for example, termination of several parts of the services or theirprovision to a particular location. The customer should take care to set out the servicesand the charges in such a way as to allow this to be done easily. The provider will wantto balance such rights against its overall business case for the services—it may beuneconomic to allow partial termination.Similarly, the customer should not be obliged to terminate the contract forthwith, ascontracts usually provide. An outsourcing cannot simply be switched off, for all thereasons set out in this book about the problems of retendering. The customer should beable to specify the length of the notice period (although the provider will want to put someoutside limit on this). The timescale for notice should then dovetail into the exitprovisions. The exit provisions should cover the specific rights the customer will requireon termination (Graham, 2003): the continued provision of the services during the noticeperiod and for any run-off period; the right to approach key members of the provider’sstaff and to offer them jobs, with either the user or a new provider; restrictions on theprovider’s ability to manipulate the undertaking that may come across to the newprovider or the customer, for example, by deploying out its best staff and deploying inless talented individuals or changing their terms of employment; and to require themigration of data and systems and the provision of information about them.As with service changes, the contract cannot spell out the details of how exit is to bemanaged; nor can this be left to be agreed at the time. The contract should therefore obligethe provider to produce a draft exit plan for consideration and agreement within areasonable time and process for agreeing it. The plan should be kept under review andtested from time to time.

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Exit Management

To contemplate the end of the relationship before it has begun can seem at best like beingoverly detailed, and at worst, a damning indictment of the future partnership betweencustomer and supplier. As a result, contractual provisions relating to exit arrangementsare frequently drafted at very high level with the only obligation undertaken by eitherparty being that detailed agreement will be reached at the time. Customers must, however,understand that a failure to specify detailed provisions exposes them to a serious riskthat at the end of the contract relationship their business will come to a grinding halt andthat they will lack the right to use crucial items of hardware and software. In addition, thecustomer will be in a far better position to negotiate favorable exit provisions prior toentering into the contract when the supplier is anxious to win the business rather thanat the time of termination when the relationship has broken down and any goodwillbetween the parties may be limited or nonexistent (Lewis & Welterveden, 2003).At the very heart of the exit provisions should be an obligation on the supplier to ensurethat there is a smooth transition of the services, either back in-house to the customer orto a third-party service provider, with minimum disruption to the business. Terms relatingto assets used and commitments to ongoing service provision during the exit periodshould be included.While the choice of technology used to provide the services would often be a matter forthe supplier’s discretion, the customer should not forget the importance of understand-ing precisely what the technology infrastructure comprises. An obligation on thesupplier to maintain an inventory for the duration of the contract of the items used toprovide the services will be helpful in this regard. This inventory should include detailsof any software (both application and infrastructure software), hardware, data, documen-tation, manuals, and details of any licenses, leases, or other arrangements relating to theservices provided.When determining the period for which any run-off services are to be required, thecustomer should take into account the complexity of the services and the anticipated timerequired to locate and implement a replacement contract with a further provider. A goodrule of thumb will be the length of time it has taken to set up the original outsourcingcontract, from the early stages of defining the customer’s requirements and selection ofsuppliers through to the go-live date under the contract. An equivalent period of timeis likely to be required to transfer services to another third party or back in house.The above provisions give the customer a certain amount of flexibility, allowing thepurchase of chunks of services in 3-month blocks. The above provisions also state thatthe existing terms of the contract are to apply to that run-off service. For example, thecustomer will be required to pay the supplier in accordance with the existing chargingarrangements and the supplier will remain committed to providing the services inaccordance with the stated service-level requirements.Provisions should then be included regarding the different types of assets that have beenused to provide the services. The supplier should return copies of the customer’sproprietary software, including copies of any modifications that have been made.Licenses should be granted to use any of the supplier’s proprietary software. Depending



on the nature of this proprietary software, the license may only be granted for a limitedperiod. Some licenses may be granted for use beyond the expiration of the exit period,although inevitably in these circumstances the customer will be required to pay acommercial rate (or close to it) for the grant of that license. It will be important to ensurethat the license provisions allow use by the customer or by a replacement third-partycontractor (Lewis & Welterveden, 2003).Licenses relating to third-party software should be provided to the customer. Copies ofdata should also be provided to the customer, together with copies of any leases,licenses, or other contracts relating to third-party items used to provide the services. Thiswill then enable the customer to assess whether those agreements should be assignedto it or whether it wishes to purchase replacement items.If premises of the supplier are used to provide the services, which the customer requiresfurther access to on termination (such as a data center), it may be possible to obtain alease to use part (or all) of those premises from the supplier. Where the premises are leasedto the supplier from a third party, this will usually be done by granting a sublease to thecustomer for the appropriate areas of the premises. The provisions of the head leaseshould be examined carefully. Consent from the lessor may well be required to anysublease and the head lease may stipulate terms that must be incorporated into asublease.A traditional debate will always center on the extent to which the supplier should berequired to transfer to the customer assets, such as hardware and other equipment, usedto provide the services. Items that the supplier has used exclusively for the customershould be transferred to the customer. Items that are not used exclusively for the benefitof the customer and that are, for example, used to provide services to a number ofcustomers pose more of a problem. In these circumstances, it may be possible for thecustomer to rent the use of part of that item from the supplier.The above provisions provide for the supplier to draw up a detailed exit plan, the aim ofwhich should be to achieve the seamless transition of the services to the customer. Thecustomer should have the right to contribute to this plan. It should explain in detail howall of the exit obligations are to be carried out, for example, the granting of licenses,notation of third-party licenses, transfer of equipment, and so forth.The extent to which the supplier is permitted to charge in respect of performing theobligations under the exit provisions is likely to be the subject of some negotiation. Theremay also be considerable costs associated with obtaining any necessary third-partyconsents to the transfer of contracts and assets to the customer. Given that the suppliercontinues to receive the basic payment for providing the services, the customer will arguethat any additional costs incurred through providing exit services should be borne bythe supplier and built into its original cost plan.The supplier is, however, likely to seek payment on a time and materials basis for anyassistance provided. This will particularly be the case if, for example, the customer hasexercised a right of partial termination of the services for convenience or where thesupplier is terminating for a material breach of the customer. It may therefore beappropriate to define some circumstances in which the supplier is entitled to payment andsome circumstances where it is not (Lewis & Welterveden, 2003).

Exit Strategy 279


Project Management

Outsourcing is often organized as a project, as discussed earlier in this book. Terminationof outsourcing might also be organized as a project. In the following, we discusstermination project management in terms of project management roles. We will apply thesame roles of leader, resource allocator, spokesman, entrepreneur, liaison, and monitor.Karlsen and Gottschalk (2002) conducted a study comparing IT executive and IT projectmanager roles. IT projects management roles were presented earlier in this book. We willargue the case that IT executive roles may be appropriate for outsourcing termination,as one alternative after termination is reestablishing an in-house IT function. The projectmanager will typically be the IT executive, who is often called chief information officer(CIO).The challenges facing IT executives are changing, as the use of IT within the organizationis maturing. The stage models of IT maturity demonstrate that the job of an IT executiveis becoming more and more oriented toward external roles (Gottschalk, 2005). The focusfirst changed from internal resource allocation tasks to corporate strategy work andcontact with users. Then the focus moved to the use of IT to gain competitive advantagesin the market place. One important IT executive role is to spend time outside the ITdepartment focusing on the strategic and organizational aspects of IT.It is reasonable to hypothesize that the IT executive is one step ahead of the IT projectmanager in the development of the external role. The IT executive is instrumental insetting up IT projects. The IT manager must first see the need for new orientations froma strategic perspective. Later on this will materialize as projects with a changed perspec-tive. According to this assumption we should expect that the most external roles (monitorand liaison) are more prominent and important among IT executives who have to handlean outsourcing termination project than among IT outsourcing project managers. Fromthe above discussion, Karlsen and Gottschalk (2002) proposed the following hypoth-eses:

• Hypothesis 1. IT executives are more externally oriented than IT project managers.• Hypothesis 1, part 1. IT executives emphasize the liaison role more than IT projects

managers.• Hypothesis 1, part 2. IT executives emphasize the monitor role more than IT

projects managers.

During the past 30 years, project management knowledge and practice (e.g., planning andscheduling systems) have been devised to cope with the challenges faced by projectmanagers. One characteristic of this development is a distinct focus on the internalactivities within the project and the base organization. Very often, little or no attentionis given to the project environment and other stakeholders, apart from the client. Mostof the project-planning models currently available consider the project as though it wasdeveloped in a vacuum. The project manager is responsible for planning, organizing,coordinating, and controlling tasks to ensure successful project completion. In order to



do this, the project manager has to allocate human, financial, and information resourcesto the project. Therefore, we expect the internal roles—leader and resource allocator—to be more emphasized among IT outsourcing project managers than among IT outsourcingtermination managers. From the above discussion, Karlsen and Gottschalk (2002) find itreasonable to propose the following hypotheses:

• Hypothesis 2. IT project managers are more internally oriented than IT executives.• Hypothesis 2, part 1. IT project managers emphasize the leader role more than IT

executives.• Hypothesis 2, part 2. IT project managers emphasize the resource allocator role

more than IT executives.

The last two management roles—spokesperson and entrepreneur—are somewhat diffi-cult to define, since they are external to the IT department/IT project and internal to theorganization. However, we should to some degree expect that the role of spokesperson(with internal orientation to the organization and other departments) is more emphasizedby IT executives than by IT project managers. The role of spokesperson is a managementrole which incorporates activities that require the IT executive to extend organizationalinteractions outside the department to other areas of the organization and top executivesas well. Frequently, the spokesperson must cross traditional departmental boundariesand become involved in matters concerning production, distribution, marketing, andfinance. The spokesperson role demands that the IT manager acts as an informationdisseminator and politician, ensuring that the IT department is properly connected to thetop level of the firm and to key decision makers in other departments. Hence, Karlsen andGottschalk (2002) propose the following hypothesis:

• Hypothesis 3. IT executives emphasize the spokesperson role more than IT projectmanagers.

The users’ needs are often the driving force behind IT projects. If articulating needs isdone insufficiently, the project will be built on a poor foundation, and major problemswill arise when implementing an outsourcing termination. As an entrepreneur, it is theIT executive’s role to identify users’ needs and develop a fully acceptable solution. Theproject manager is required to provide innovative solutions for the product, as well asthe business processes involved in the achievement of the project’s outcome. Clientconsultation, communication, listening, feedback activity, and client acceptance arecritical project success factors. Hence, Karlsen and Gottschalk (2002) proposed thefourth and final hypothesis:

• Hypothesis 4. IT project managers emphasize the entrepreneur role more than ITexecutives.

Exit Strategy 281


A survey of IT project management roles was conducted in Norway in 2001. Seventycompanies responded to the survey, as reported earlier in this book. Another survey ofIT executive management roles was conducted, resulting in 128 responding companies.As you may recall, on a scale from 5 (very important) to 1 (not important), the leader roleachieved the highest score (4.3) for project managers, followed by the resource allocatorrole and the spokesperson role (both 4.0), the entrepreneur role (3.7), the liaison role (3.4),and the monitor role (2.3). For IT executives, the entrepreneur role (4.4) achieved thehighest score, followed by the spokesperson role (4.2), the leader role (3.9), the resourceallocator role (3.8), the monitor role (3.7), and the liaison role (3.2).Hypothesis 1 examines whether IT executives are more externally oriented than IT projectmanagers. This hypothesis had two subhypotheses. Statistical analysis shows that ITexecutives are significantly more externally oriented than IT project managers. However,only one of the subhypotheses was supported. The analysis of statistical variance gavesufficient statistical evidence to conclude that IT executives emphasize the monitor rolesignificantly more than IT project managers. However, this was not the case for the liaisonrole.Hypothesis 2 examines whether IT project managers are more internally oriented than ITexecutives. Statistical analysis supports the main hypothesis that IT project managersare significantly more internally oriented. Both subhypotheses of leader and resourceallocator roles are also supported.Hypothesis 3 examines whether IT managers emphasize the spokesperson role more thanIT project managers. The hypothesis is not significantly supported.Hypothesis 4 examines whether IT project managers emphasize the entrepreneur rolesignificantly more than IT executives. This hypothesis is significantly supported.To summarize, we have illustrated the importance of each management role in Figure 12.1.The study by Karlsen and Gottschalk (2002) yields some results to improve theunderstanding of managerial role priorities of IT executives and IT project managers. Inour current context of IT outsourcing termination projects versus IT outsourcing project,we have interpreted the IT executive as termination manager and the IT project manageras outsourcing manager. Such interpretation has obvious shortcomings, and future

Figure 12.1. Differences between management roles

ENVIRONMENT


CORPORATE PROJECT ORGANIZATION Leader role* Resource allocator role**

Liaison role Monitor role*

Spokesperson role Entrepreneur role**

*IT executives emphasize this role significantly more than IT project managers.** IT project managers emphasize this role significantly more than IT executives.



research should investigate project management roles explicitly for the two situationsof IT outsourcing and IT outsourcing termination.

Conclusions

The advice from companies that have experienced tough times in outsourcing seems tobe: Think exit before signing an outsourcing contract! Agree on a back-out plan, definecommunication between outsourcing vendors during transition, avoid outsourcer bank-ruptcy, and consider a progressive approach to negotiating an outsourcing agreement.

Case Studies: Exit Strategy

Rolls-Royce had an exit strategy because of the length and size of the contract. Theseplans already existed, the resources were already identified, and the major activities wereall in place. In the context of commitment to the board, the CIO was the risk owner. Hereported up to an overall risk committee. Directors in the company had the responsibilityto identify all major risks in the business, and to have plans in place to both contain themwhen they occur and to avoid them happening. Exit strategies were important both froma risk perspective and from a performance failure perspective.In the SAS–CSC deal, there was agreed-upon termination clauses, which, to a certainlevel, described rules and procedures for termination. In the Transition Agreement, therewere identified activities to refine the operational description of the parties’ obligationif termination occurs. SAS were discussing possible exit scenarios, any they had startedto work with an exit strategy.The global deal of ABB–IBM had a schedule called Exit Management, where terminationclauses were defined as the two parties’ rights and obligations in case of exit. The bottomline of the schedule was how much it cost to quit. For each year, there were defined costs,sinking as the years go by. If several countries used the termination clause, this wouldrelease a global renegotiation. Beyond the economical clauses of termination, there hadnot yet been developed exit plans.

Conclusions 283


Conclusions

Managing successful IT outsourcing relationships is both a demanding and a rewardingactivity. Important success factors include a business-oriented enter strategy, optimalphases and activities, a goal-oriented contract development, an effective handling ofpersonnel issues, transparent governance structures, cost controls, knowledge manage-ment, and a business-oriented exit strategy.Business-oriented enter strategy can build on resource-based theory, transaction costtheory, activity theory, agency theory, or other theories of the firm. The business-oriented enter strategy develops an understanding of the value configuration of the firmto understand the role of IS in primary and secondary activities. The strategy definesvision, mission, and objectives of the firm. It includes changes in electronic business andother important business areas that impact future use of IT. The strategy analyzesdistinctive IT nature in the firm, sourcing categories, IT challenges, and selectiveoutsourcing. The Y model can be applied for strategic IT planning to define depth andbreath of potential outsourcing. The result of a business-oriented enter strategy areoutsourcing preparations.Optimal phases and activities can build on the standard phases of vision, evaluation,negotiation, transition, performance, and improvement. However, a contingent approachof understanding the specific situation of the firm can cause phases to change andactivities within each phase to be altered. For example, if a pilot outsourcing is the resultof the business-oriented enter strategy, and then a negotiation phase will occur twice,both before and after initial transition.Goal-oriented contract development is concerned with transparent contract structure,successful asset transfer, balanced risk sharing, cost-effective technology upgrading,optimal contract duration, defined relationship management, acceptable fee arrange-ments, and dispute resolution without personal conflicts.



Effective handling of personnel issues includes humane and predictable human re-sources management in times of IT staff reduction and transfer, employment protection,pension considerations and handling of persistent managerial expectations. For example,transferred IT personnel from client to vendor may not be employed to work with theprevious employer. Rather, a contingent approach can imply that transferred personnelare trained in new areas to serve other vendor clients.Transparent governance structures may be based on the interaction approach. Manage-ment control systems have to be implemented, including regular performance measure-ments. Partnering relationships have to be defined, and acceptable partnership qualityhas to be achieved. All stakeholders have to be considered and included in thegovernance structures. Both hard and soft sides of outsourcing have to be included inthe governance structures.Cost controls include both production and transaction economics. Hidden costs are ofparticular interest, as well as contract termination costs. To appreciate the cost–benefitratio of outsourcing, both planned and unplanned benefits have to be included in theequation.Knowledge management is important to strengthen know-what, know-how, and know-why for both the vendor and the client. Knowledge transfer mechanisms have to beinstalled to handle troubleshooting, technology upgrades, and emerging businessneeds.Business-oriented exit strategy can build on resource-based theory, transaction costtheory, activity theory, agency theory, or other theories of the firm. The business-oriented exit strategy develops an understanding of the value configuration of the firmto understand the role of IS in primary and secondary activities. The strategy definesvision, mission, and objectives of the firm. It includes changes in electronic business andother important business areas that impact future use of IT. The strategy analyzesdistinctive IT nature in the firm, sourcing categories, IT challenges, and selectiveoutsourcing. In particular, the business-oriented exit strategy summarizes experiencesfrom the current outsourcing arrangement and analyzes strengths and weaknesses of thecurrent vendor. The strategy identifies and analyzes strengths and weaknesses ofalternative sourcing options, including identified vendors and insourcing. The Y modelcan be applied for strategic IT planning to define depth and breath of potential exitoptions. The result of a business-oriented exit strategy is contract termination, combinedwith a new sourcing decision.Managing successful IT outsourcing relationships is concerned with exploitingoutsourcing opportunities and avoiding outsourcing threats. We should remind our-selves of some of the outsourcing threats suggested by Barthélemy (2003b) to avoidthem. Outsourcing activities that should not be outsourced can be avoided by thoroughunderstanding of business goals, company boundaries, and resources. Selecting thewrong vendor can be avoided by exploring both contractual and relational reactions ofpotential vendors. Writing a poor contract can be avoided by organizing a qualifiedcontract team that includes a good lawyer. Overlooking personnel issues can be avoidedby retaining key employees and securing transfer of employees to the vendor. Losingcontrol of the outsourced activity can be avoided by complementing vendor managementskills with technical skills. Overlooking hidden costs of outsourcing can be avoided by

Conclusions 285


identifying search and contracting costs, vendor management costs and other poten-tially hidden costs. Failing to plan an exit strategy can be avoided by explicitlyanticipating the end of an outsourcing contract before it is signed.Furthermore, managing successful IT outsourcing relationships is concerned withavoiding outsourcing risks. We should remind ourselves of some of the outsourcingrisks suggested by Earl (1996) to reduce them and possibly avoid them. Possibility ofweak management can be avoided by replacing and strengthening existing IT manage-ment after outsourcing. Inexperienced staff can be avoided by interviewing and testingvendor staff. Risks from business uncertainty can be reduced through flexible contractsthat are both flexible in scope and time. Outdated technology skills can be avoided byinterviewing and testing vendor staff on a regular basis, which is specified in the contract.Endemic uncertainty can be reduced by regular measurements in terms of user surveysand other research instruments. Hidden costs, again, can be avoided by identifyingsearch and contracting costs, vendor management costs, and other potentially hiddencosts. Lack of organizational learning can be reduced by project-based systems devel-opment and operations, where both client and vendor personnel participate in theprojects. Loss of innovative capacity can be reduced by slack resources, organic andfluid organizational processes, and experimental and entrepreneurial competencies.Dangers of an external triangle should be avoided by direct contact between problemowner and solution provider. Technological indivisibility can be reduced by modulardesign, flexible application architecture, common data architecture and modular infra-structure. Fuzzy focus can be avoided by always answering the “what” question (Whatdoes the business want to achieve?) before the how question (How can IT support thebusiness in achieving what it wants?).Finally, let us look at another set of outsourcing risks as suggested by Bahli and Rivard(2003). Lock-in can be reduced by low asset specificity, large number of suppliers, andthe client’s high degree of expertise in outsourcing contracts. Costly contractualamendments can be reduced by systematic forecasting of changes in the businessenvironment and in the internal environment. We can make distinctions between dynamicand turbulent environments. An environment perceived as dynamic, is changing fast, butwe do understand what is going on. An environment perceived as turbulent, is changingfast, and we do not know what is going on. In the latter circumstances, not onlyoutsourcing, but also the whole business, is at stake, as management does not under-stand what is going on. Change of management is probably needed. Unexpectedtransition and management costs can be reduced by improved understanding of thefuture and improved expertise in IT operations. Disputes and litigation can be reducedby frequent measurements, IT expertise, and professional relationships.

286 References


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298 About the Authors


About the Authors

Petter Gottschalk is professor of information management at the Norwegian School ofManagement, Norway. He teaches strategic knowledge management and technologymanagement strategy to undergraduate and graduate students in Norway, China, andEgypt. He is the author of several books on these topics, and he has published in majorjournals. Professor Gottschalk earned his MBA at the Technical University Berlin,Germany, his MSc at Dartmouth College and Sloan School, MIT, and his DBA at HenleyManagement College, Brunel University, UK. His executive experience includes CIO atABB and CEO at ABB Datacables. See http://www.bi.no/users/fgl98023/ for a detaileddescription of education, publications, and management experience. Professor Gottschalkhas contributed several articles to Idea Group journals, several chapters to Idea Groupbooks, several papers to the IRMA conference, and his first book published by IdeaGroup, Strategic Knowledge Management Technology, was released July 1, 2004.

Hans Solli-Sæther has a master of science degree from the University of Oslo and abusiness candidate degree from the Norwegian School of Management. He has been CIOof Norway Post and has several years of experience with IT outsourcing. Solli-Sæther isnow a doctoral candidate at the Norwegian School of Management, Norway, and hisdissertation research is focused on managerial expectations in IT outsourcing.

Index 299


Index

A

ABB 4, 125activity-based theory 104agency

costs 90, 103theory 89

agent 91analysis framework 131applications service providers 131ASP 12asset transfer 170atmosphere 213

B

back-out plan 272behavioral control 90belief perseverance 191benchmarking 161benefits 247British Aerospace 120British Petroleum (BP) 7business

application outsourcing 12process

management 259

outsourcing 14risk 171

C

capabilities and resources 93cognitive style 190company boundaries 99contingency model 103contract

development 168, 181duration 173management 181structure 168termination 274

costs 246contractual theory 78costs of coordination 72CSC 4

D

de facto insourcing 130dispute resolution 178distinctive IT nature 127due diligence 174DuPont 69

300 Index


E

e-business 16infrastructure 38maturity 15models 38

EDS 4employment protection 185enter strategy 127evaluation 156exit 271

management 276strategy 271

F

fee arrangements 177financial

assets 206risk 171

four exchange episodes 213

G

global outsourcing 136governance structures 205

H

hidden costs 244human assets 206

I

IBM 4improvement 159information and IT assets 206infrastructure services 48innovation diffusion 18insourcing 134intellectual

capital management 254property 206

interaction approach 212interfirm relations 36IT function organization 57IT infrastructure 46IT outsourcing markets 10

K

knowledge management 254technology 260

L

limitations for outsourcing 120long-term relationships 213

M

management control systems 215managerial expectations 195mature 162maturity 15

N

negotiation 157neoclassical economic theory 77NetCom 68

O

outcome-based control 90outsourcing

costs 252decisions 10definitions 19opportunities 60performance 58preparations 135relationships 175termination 273threats 62

P

partnering relationships 222partnership

and alliance theory 105quality 223

pension considerations 186performance measurement 218personnel issues 184phases and activities 155postcontract management 83principal 90production costs 239

Index 301


project management 147, 278public sector 180

R

reduction in IT staff 184relational

contract theory 84exchange theory 108

relationshipassets 206management 176phases 164

resourcemobilization 101-based

strategy 100theory 91

risk sharing 171Rolls-Royce 4, 26

S

SAS 4, 70selective outsourcing 130, 132sensemaking 189services outsourcing 52short-term exchanges 213slack resources 97social exchange theory 117sourcing

categories 130levels 129

stages of technology growth 263stakeholder

expectations 187theory 112

stakeholders 228strategic

IT planning 140risk behavior 249

successful relationships 60

T

technical risk 172technology upgrading 172theory of core competencies 85

theory of firm boundaries 114total

insourcing 130outsourcing 130

transaction cost 239theory 71

transfer ofassets 169IT employees 203

transformational outsourcing 7transition 158transplant perception of role 201

V

valuechain 29configurations 28, 35network 33shop 30systems 36

vendor value proposition 52, 258vision 155

W

winner’s curse 163

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