By Robin Gareiss
InformationWeek

Ah, the start of a promising courtship, the dreams and hopes for a happy future together. Then the first (then the second and the third) disagreement surfaces, and the reality of melding backgrounds, ideals, and goals looks so complicated.

So it is with the continuing love affair between corporate America and the outsourcing companies that run their business-technology systems. But surprisingly, this long-running, sometimes stormy romance is doing better than most marriages. Two-thirds of companies say their outsourcing experiences have met expectations, according to 700 business-technology professionals in InformationWeek Research's Analyzing The Outsourcers study.

As in love, the perfect mate might not be the beauty queen. We asked customers to rank their satisfaction with their outsourcers, and the best-known names in the business, IBM and EDS, don't top the list. No. 1 is Hewlett-Packard, a company some consider a sleeping giant among outsourcing providers because it's better known for hardware, followed closely by Sprint and Accenture. The differences separating the companies were fairly close, with the exception of one: WorldCom, which ranked a distant ninth.

Alas, few of these unions reach the level of bliss. Only 8% say their outsourcing relationships exceeded expectations, and one in five says they haven't lived up to expectations. On a 1-to-10 rating scale where 10 is extremely satisfied, most scores ranged between 6 and 7. Respondents are most impressed with outsourcers' industry knowledge, range of services, reliability, and skill, which all averaged 7.5 or higher, but less impressed with cost/value (6.8), innovation (6.7), and strategic advice (6.6). Customers want a company that's reliable, technically skilled, and able to save them money. They're less worried about an organization delivering strategic advice and innovation.

Even as they rank outsourcers' performance, these business leaders know they're the ones responsible for making the relationships work. Executives experienced in outsourcing tick off a few keys to success, including detailed service-level agreements, realistic commitment of management time, and accurate cost-saving estimates. And it's almost always going to be tougher than expected. "There's absolutely no doubt that if you're entering into an outsourcing environment, it's going to take more time than you imagined," says Keith Morrow, CIO for convenience-store chain 7-Eleven Inc. "You could do it with a hands-off, laissez-faire approach, but you'll double your costs." The greatest dissatisfactions from these relationships are that they take more management time than anticipated and they don't live up to performance expectations.

Nearly half of the respondents underestimated the amount of management time their outsourcing deals required. "When companies turn to outsourcing, their initial idea is that they're going to go in and hand over everything," says Tim Wilson, senior analyst with consulting firm Enterprise Management Associates. The level of involvement varies, but executives experienced in successful outsourcing deals say it's vital to stay directly engaged.

Continental Airlines Inc. CIO and senior VP Janet Wejman, for example, wants to maintain frequent contact with EDS, which has a 10-year, $1 billion deal to run Continental's data center, network, and legacy systems. To do so, she's had to make it clear to EDS managers that they must let her know, directly and immediately, of any major problem -- no matter what time it happens. "The outsourcers were originally confused by the fact that if any airport IT system goes down, I want to know about it," she says. "If an airport goes down in the middle of the night, I want them to know that I'm awake. If they think I'm sleeping, they'll think they've got more time to fix the problem." Such expectations need to be spelled out at the start of the relationship, with an understanding of how the outsourcer's action will affect the amount of time CIOs spend managing the relationships. When EDS appoints a new account manager for Continental, Wejman needs to spend time making sure that person understands things such as when it's necessary to make the midnight phone call. That's why it's written into the contract that the airline must be involved in EDS layoff discussions, so Wejman can tell EDS executives which people the airline values most highly.

The outsourcer's staff should be viewed as part of the team and their skills allocated to get the job done, Nextel CIO LeFave recommends.
It's a responsible move for any CIO who views outsourcers as part of the IT staff. "You never outsource the responsibility, just the execution," says Dave LeFave, CIO at Nextel Communications Inc., which hands over about 60% of its IT operations to EDS, IBM, and Amdocs, a communications industry outsourcer. He expects his managers to view the vendors' employees as part of the team and allocate their skills to get the job done.

LeFave also spends time educating the CEO and CFO about the contract and what to expect -- both good and bad. "As much as you try to prepare yourself, within the first year of an agreement you're going to find things you didn't expect," he says. "So conditioning people for that is very important."

Outsourcing customers put trust high on their list of criteria -- 85% rank it highly important, the second most-often mentioned trait -- but at the start of most deals, there's inevitably an us-versus-them attitude on both sides. It's up to senior management to spend time dispelling that through monthly or quarterly meetings to discuss performance, problems, or strategy. The American Automobile Association is very concerned about outages, so its internal staff understands how critical it is to quickly get things running again. "With outsourcers, we have to create that sense of urgency," CIO Satish Mahajan says.

But Dan Rosman says the time he spends managing outsourcing is going down. The IT director for Jelly Belly Candy Co., a privately held company with more than $100 million in annual revenue, has outsourced its E-commerce applications to Accenture for nearly a year, and now he reviews Accenture reports and gets involved only when problems arise.

After years of outsourcing experience, Jim Saber, CIO of bank holding company Providian Financial Corp., says that making internal executives accountable is paramount. When outsourcing deals fail, he says, it's almost always because the CIO shifts responsibility to the outsourcing company. "Outsourcers must be one component of your resource pool," Saber says.

The No. 1 reason companies turn to outsourcers is to save money -- 64% say that's the main goal of their outsourcing contracts -- yet many aren't happy with the results they're getting. Respondents ranked Sprint No. 1 for cost/value, followed by HP and Computer Sciences Corp. At the bottom are IBM and Accenture. Companies generally report lowered costs with outsourcing, but at the outset, many overestimate the savings and underestimate the costs. Thirty percent of respondents say their cost savings fell short of expectations, and 38% complain of unexpected add-on costs after their contracts began.

But that suggests seven out of 10 are pleased with their costs savings, as Overhead Door Corp. is. The specialty door maker uses Sprint to manage 95% of its data-center infrastructure, which should shave $1.2 million off Overhead Door's costs over the three-year contract. Farmers Insurance Group saves about half of its IT labor costs by outsourcing IT maintenance tasks to Wipro Technologies, an offshore firm (see story, "Team Building: Managers' First Job Is Building Trust"). Most large U.S. outsourcers claim that on average, they reduce customers' IT costs by 20% to 30%.

Outsourcing is time-consuming, 7-Eleven's CIO Morrow says.
The savings can be tough to measure. 7-Eleven has been outsourcing so long it's hard to quantify the cost of running its own mainframe and midrange data centers and network management. But CIO Morrow puts a premium on being able to leverage the outsourcer's buying power and adopt new platforms and technologies more quickly than if operations were in-house. "You can follow the technology curve much better with outsourcing," he says. In this sense, Morrow is in the minority -- only one in five survey respondents considers innovation or cutting-edge technology a main goal in an out- sourcing relationship. Good thing, because it isn't outsourcers' strong suit; they got their second-lowest average scores for innovation, trailing only strategic advice.

A frequent complaint is that vendors charge extra for labor, software licenses, or other areas after a contract has begun. "We haven't figured out a way to manage it," says Mike McVeigh, senior systems engineer for the Federal Aviation Administration, which uses a variety of vendors, including IBM and Tivoli, Lockheed Martin, Raytheon, and WorldCom. "The vendor is trying to buy low and then add after the contract begins." The FAA tries to keep add-on costs under 10%, but there have been large projects for which those costs were doubled.

One solution: Managers need to build extras into the budget, because they're a given. Continental prepares for extras by setting a price up front for everything and paying as it goes each month. For instance, the contract outlines set prices for each processor or for each new piece of hardware at an airport.

One reason companies don't always save what they hoped to, especially with their first outsourcing deal, is because they don't have the correct internal staff: They don't lay off enough people to get savings, or they lay off too many. "They almost never get it right," says Douglas Frederick, executive VP for EDS. Sometimes the staff that remains is so small that employees don't have the resources to optimize the work. It often takes up to a year to balance it out. Companies are better at determining staff levels the second or third time they outsource, Frederick adds.

They're also smarter about their contracts. In outsourcing, flexibility is the key. It's crucial to write in terms that allow for changes in costs and service-level agreements and give either side the option to cancel. "Driving costs out of an outsourcing agreement is a tricky situation," Providian's Saber says.

The terms of contracts should be re-evaluated often, and outsourcers should pass on their savings to customers, Farmers Insurance CIO Claudio says.
One way to do that is to include terms that require the outsourcer to re-evaluate the contract often and pass on hardware and software savings. Farmers Insurance CIO Cecilia Claudio recalls her tenure at Xerox Corp. about 12 years ago when she was involved in one of the largest outsourcing deals of the time. Hardware prices were falling, but the contract didn't specify that the vendor, EDS, had to pass on the savings. "As the outsourcer achieves lower cost of ownership, they should and must pass that on," she says.

CIOs must be responsible for regularly benchmarking their companies' costs against their industry overall. "When you do desktop analysis and find out your desktop costs are twice as much as others, then you're not doing a good job," Nextel's LeFave says. And it's time to reassess the contract.

General Motors Corp., which has probably the most extensively outsourced IT operation in the world. Twice a year, it gives its top 17 outsourcing suppliers report cards that rank each vendor in about 20 categories. But when it comes time to replace a poor-performing vendor or get several vendors bidding on a contract, the short list of viable choices can be far too small. GM CIO Ralph Szygenda is working with some of the automaker's vendors, which he declines to name, to get them to create service businesses. He and his business-unit CIOs also force vendors to work together, since too often they don't have the means to handle the size or complexity that GM needs individually. After spending his first years with GM unraveling its exclusive service deal with EDS -- a company that remains a critical partner -- Szygenda is determined not to get cornered by limited choices. "My biggest problem is I don't have enough suppliers," Szygenda says. "There aren't enough competitors."

After companies pick their outsourcing suppliers, one of the first steps to making a deal is certain to be writing a service-level agreement. Prenuptial agreements may be controversial in marriage, but they're a vital safeguard for both sides in any outsourcing relationship. Although reliability and trust top the list of what buyers look for in an outsourcer, CIOs say it's in service-level agreements where numbers are put to those ideals, defined by standards ranging from server uptime to transaction response time and even revenue.

Service-level agreements don't disappear into a drawer after an outsourcing contract is signed. Among large companies, 70% have invoked the terms of their agreements one or more times, and 41% of all companies have invoked them multiple times, according to InformationWeek Research. Doing so puts a strain on the relationship. "Very rarely have I seen clear-cut examples of someone saying, 'Yep, you're right, I've missed the SLA, and here's your check,'" says Saber of Providian, which outsources its Web site to WorldCom, its credit-card operations to Total Systems, and is speaking to IBM about handing over its data center. "There's always discussion and argument."

HP, Sprint, and CSC do the best job when it comes to executing service-level agreements, while WorldCom and AT&T are the worst, according to survey respondents. HP tries to exceed its agreements and measures performance against objective business results, says Joe Hogan, VP of marketing for HP Managed Service. And when it messes up, it pays up. "The customer has a level of expectation, and if performance doesn't occur to that level, there really should be some type of liability to the outsourcer," he says.

WorldCom execs say its operating skill is getting a bum rap because of its accounting scandal and the related bankruptcy. "One of the false perceptions is that our service-level quality could be in jeopardy," says Dennis Richardson, director of managed-service solutions. "Our metrics continue to show that we're meeting service standards." There's no doubt the company's reputation is hurting. It ranked ninth in every category but cost/value, where it ranked seventh.

The first step toward creating effective service-level agreements is knowing what you need before sitting down with an outsourcer. Before revamping its deal with EDS, Continental spent months identifying and prioritizing its systems to calculate appropriate agreements. "You have to figure out the service levels needed to run the company," CIO Wejman says.

And the penalties need enough teeth to keep the vendor's attention. Though Wejman is pleased with the service EDS provides, Continental's IT systems, using customized monitoring software, automatically invoke substantial penalties outlined in the outsourcing contract when EDS doesn't meet a service level, which typically happens about once a year. "It doesn't compensate for our loss in revenue, but it gets senior-management attention, and there's no forgiveness," she says. Wejman adds that the fine is hefty enough that it goes across the desk of EDS CEO Dick Brown, ensuring that the problem gets immediate attention and repair.

Pinpointing the appropriate penalty is the tricky part. Businesses typically want to tie penalties to revenue losses, but vendors resist that because liabilities could be huge. Outsourcers generally get penalized less than it costs businesses but may pay in other ways. "Most companies don't want to earn a penalty because the amount of penalty won't make up what they'll lose in business," says EDS's Frederick.

Some executives think there's room for reason in outsourcing relationships, especially early on. "When we bring a new person or company in, we give them a runway," says Nextel's LeFave, who has negotiated seven deals. For instance, Nextel is giving EDS a six-month grace period as it moves Nextel's data center from Atlanta to Charlotte, N.C. On the other hand, Nextel renegotiates and ratchets up its service-level agreements each year. Amazingly, Nextel hasn't had to invoke any fines with any of its outsourcers.

Rather than pay substantial penalties, outsourcers try to work into their agreements options to earn back penalties -- if a vendor doesn't meet a service level one month, it can earn back that penalty based on superior performance the following month. But Providian CIO Saber warns that because outsourcing vendors are more experienced at the bargaining table, they're better equipped to write service-level agreements to their advantage. So rewarding outsourcers for superior performance must be tied tightly to business value and financial gain, he says. For instance, a hosting vendor suggested Providian pay a bonus for consistently providing 100% uptime. "If I wanted it at 100%, I'd ask for it," he says. "If you're not driving business value to me, I won't pay it."

Accenture prefers to measure performance by the success of a business and earn a bonus based on financial results -- as well as pay a penalty when it fails. Accenture runs all IT, computing, and applications for the London Stock Exchange under a deal that ties its bonus to the exchange's ability to process transactions. "If you're always using a stick on a provider, it's hard to give it an incentive to perform better than the base level," says Martin Cole, managing partner for global outsourcing at Accenture.

Another key for service-level agreements is to make sure they're flexible. As companies' needs change, IT executives must be able to renegotiate the agreements. 7-Eleven outsources 75% of its IT operations, including its mainframe data center to Affiliated Computer Services, midrange data center to EDS, help desk to Telvista, and network operations and management to AT&T. The convenience-store chain reworked its service-level agreements after Sept. 11, to include getting more granular network monitoring. And 7-Eleven made substantial changes to security relating to response time and limits of liability.

As the emphasis on service-level agreements suggests, an executive's relationship with an outsourcer in many ways is marked foremost by caution: "I'm bringing you in to save us money; don't screw it up." The slow economy, coupled with bankruptcies such as WorldCom's, have heightened executives' financial concerns. Six out of 10 survey respondents consider financial viability and size to be highly important. The companies have had their financial challenges, with the market capitalization for the publicly traded outsourcing firms we rated dropping nearly 47% in the past three years. In an effort to boost revenue, many vendors have expanded their offerings. "But the depth isn't there anymore. Many don't have a core group and a core expertise anymore," 7-Eleven CIO Morrow says. "Now, it's 'We do everything.' At the same time, technology has become more complex."

Executives are clearly spreading their risks across multiple outsourcers, including small and midsize vendors focused on specific areas. While we rated nine top firms, nearly everyone interviewed for this story had multiple outsourcing relationships, including many with ties to firms in India for application development or software maintenance. Two-thirds of people surveyed cite companies outside this top nine as among their three main outsourcing providers. Still, Enterprise Management Associates' Wilson recommends checking the books of outsourcing partners, big and small. "I'd look for a company that will be around for years to come," he says.

It's also clear that, differences aside, outsourcers and their customers are cautiously increasing their commitments to one another. A third of companies say they'll increase spending with outsourcers next year, and 44% will keep it the same. Almost 40% say they're more reliant this year than last on outsourcers, while only 17% say they're less reliant.

Continental's Wejman offers an example of why. Outsourcing relationships aren't always perfect, but she likes the fact that she doesn't have to worry about mundane necessities such as battery-powered backup in her data center. "I can focus on more important things to Continental's business," she says. That's the kind of value in a relationship that can be tough to measure. But it's even tougher to do without it.