An introduction to IT outsourcing

This guide is based on UK law. It was last updated in February 2008

Introduction

The pressures which lead organisations to outsource show no signs of slackening and cost savings remains a major incentive. However, other factors are increasingly influencing the decision to outsource – access to innovation, increased speed to market, and service quality are proving equally as important as cost savings.

As the value of transactions has increased, so too has the range of outsourced services. Most non-core services which organisations have traditionally provided internally – IT, finance and accounting, HR and property management - are now commonly outsourced. The locations from which services are provided have also changed – the attraction in outsourcing to offshore locations such as India has soared.

Reports show that the fastest growing sectors are business process outsourcing and business process management. For many large IT suppliers outsourcing and process management are one of the few areas to have flourished in the difficult market of recent years.

What is outsourcing?

Outsourcing involves the transfer of the responsibility for carrying out an activity (previously carried on internally) to an external service provider. The service provider in turn provides services back to the customer against agreed service levels for an agreed charge. In many outsourcings the transfer of the activity involves the transfer of staff and assets (see the employment section below).

Outsourcing is often characterised as having 3 distinct phases:

• The customer transfers the existing service to the service provider;
• The services are provided by the service provider;
• Termination/expiry, which may involve either:

(a) renegotiation/renewal of the service contract; or
(b) exit management either by:

(i)   the service being brought back in-house (in practice this is rare); or
(ii) the appointment of a new service provider (most likely course).

Outsourcing is not a new concept: many organisations are into their second or third generation of outsourcing. Traditionally the financial sector and the motor, defence and aerospace industries have dominated the outsourcing market. In the construction sector outsourcing is not unfamiliar but is a more recent phenomenon. Contractors have outsourced as customers to third party service providers. They have also, and increasingly, set themselves up to provide outsourcing/FM services to their clients, having identified outsourcing as a means of securing long term profit growth. In this briefing we look at contractors outsourcing as the customer and we focus primarily on IT outsourcing. We take a look at the pros and cons of outsourcing, issues relating to employees, global deals and off-shoring, and how to plan and prepare for a successful outsourcing.

What are the pros and cons of outsourcing?

The reasons for outsourcing IT are varied but some of the most frequently cited drivers include:

• Reducing IT costs through efficiencies and economies of scale on the part of the service provider 
• Access to world-class IT skills, experience and resources
• Removing non-core business
• Minimising sizeable capital expenditure on IT infrastructure
• Certainty of future IT spend

In practice the benefits of outsourcing tend to be spread across the above areas. Those seeking to outsource to achieve cost reductions alone may very well be disappointed.

The potential downsides to outsourcing include:

• A loss of control over a crucial business service
• A lack of flexibility in the services received
• Damage to staff morale/culture clashes (between the service provider and customer)
• The distraction of having to manage the relationship with the service provider

The number of companies choosing to outsource continues to grow so, for many, it seems that the potential benefits outweigh the downsides. However the benefits of outsourcing will only be realised if the customer is well prepared, the outsourcing contract contains sufficient detail and the ongoing relationship is managed effectively - it is an old adage that one should never outsource a problem, but unfortunately, this frequently occurs.

Planning for an outsourcing

Outsourcing disasters get reported frequently but successful outsourcing deals rarely get the same press. Like any commercial transaction, outsourcings can go wrong, but the mistakes that contribute to their failures can be avoided. Investing effort in the early stages of the outsourcing and good management of the relationship once it is implemented can help to prevent an outsourcing disaster. For example:

• Have a robust business case to support the decision to outsource with senior executive backing 
• From a technical point of view, know and understand your existing IT operation and what you seek by way of external IT services from the service provider
• Commercially, know and understand your existing IT estate and its cost base in sufficient detail to enable you to evaluate whether the pricing model proposed by the service provider provides value for money
• Consider what form of organisation is best placed to meet your objectives.  Should you use a single provider or seek multiple providers for specialist services?  Do you require multiple providers to form a joint venture or consortium?
• Conduct your own due diligence on third party contracts and licences to ensure that your third party software and hardware licences permit use by the service provider (either by way of consent or through assignment or novation of the contract) – failure to do so could lead to potential breaches of the contract or licence and additional charges from the third party vendor
• Provide for the future – as the customer you have an interest in ensuring that at the end of the outsourcing the services can be transferred seamlessly back to you or to another service provider. Prepare and agree at the pre-contract stage and during contract negotiation an orderly transfer procedure – this will give you assurance that you are not locked in to one supplier and that termination is a practicable option
• Legally, be prepared to negotiate the finer details of the outsourcing transaction so that the terms can be documented in the services agreement

Employment issues affecting outsourcings

The Transfer of Undertakings (Protection of Employment) Regulations 2006 (normally called 'TUPE') will apply to almost all outsourcings where the activity to be outsourced is currently based in the EU.  The effect of TUPE applying will be to transfer the employees engaged in the relevant services from the customer to the provider.  Where one provider is replaced by another, the employees will transfer from the outgoing provider to the new provider.

TUPE transfers the rights and liabilities associated with the employees from the old employer to the new.  For instance, if an employee of the customer has a claim for race discrimination against the customer, liability for that claim will pass to the provider when the employee transfers.  New liabilities can arise if the outgoing and incoming employers fail to comply with obligations under TUPE to inform and consult employees.  The services agreement therefore usually contains appropriate warranties and indemnities in relation to the parties' liability for the transferred staff prior to the transfer, post transfer and on exit.

Other employment law developments affecting outsourcing transactions include the following:

• A recent case has established that TUPE can apply even where a service is "offshored".  This creates risks both for the customer and the offshore provider which previously would have been thought not to exist
• TUPE now requires the outgoing employer to provide the incoming employer with specified information about the transferring employees.  Failing to do so can give rise to claims for compensation
• Although occupational pensions do not transfer under TUPE, certain rights under these schemes may do so.  In addition, pensions legislation now requires a new employer to make pension contributions for transferring employees where the old employer contributed to an occupational pension scheme.

The global dimension

Growth in the globalisation of markets has led to an increase in global outsourcing transactions.  Multinational companies are seeking to provide implementation and management of their technology and other business processes on a worldwide basis.  Normally there is a requirement for a consistent level of service in all countries in which the customer is present and the ability to deliver that same service in countries that are targets for expansion.  This requirement for "global reach" means that, in practice, very few service providers are able to deliver the range of the services required and global deals tend to be concentrated in the hands of very few players.

The main issues to be considered in global deals include:

• The customer should satisfy itself as to the ability of the service provider to meet its global requirements.  Evidence of a strong track record in supplying services around the world would need to be produced
• It is essential that the legal structure of the arrangement works.  A customer will usually enter into a global framework agreement which will be applied in all the countries in which services are delivered.  There are complex legal issues that need to be considered in such arrangements.  For example, the legal system that is to apply and how (and where) disputes are to be dealt with will need to be considered
• The customer should be satisfied with the manner in which the service provider's technical solution is to be delivered – especially in relation to an IT outsourcing.  Are services to be delivered locally or are they to be delivered remotely?  If the latter, how are back-up and maintenance services to be provided?
• There are complicated tax issues to be considered in global transactions – especially in relation to withholding tax.  Customers need to take advice at the earliest stage to ensure that the contractual structure is correct
• Global deals may involve the cross-border sharing of personal and other sensitive information and care needs to be taken in connection with data protection issues.  The approach to data protection varies significantly between countries

Off-shore services

Businesses are increasingly looking to move their functions to an offshore destination – whether the services in question relate to the provision of call-centres, mass business processing or highly specialised software development.  Issues to consider when a customer is considering buying off-shore services include:

• What is the relationship between the domestic supplier and the off-shore provider?
• Will the domestic supplier take primary liability for all services delivered?
• Will the off-shore services be subject to the same legal and regulatory regime (for example in relation to date protection) as any on-shore services?
• Who will audit the off-shore services and remedy inadequate delivery?
• "Softer" issues will also need to be considered such as whether it is necessary to ensure that the off-shore provider has a sufficient degree of familiarity with the geography and idioms of the customer's market (for example, in dealing with consumers' enquiries to a call centre)

Managing the outsourcing relationship

Once an outsourcing deal has been concluded committed management of the outsourcing relationship is critical to its success. A successful outsourcing requires processes and procedures for managing the relationship between the customer and the service provider: for example, regular service meetings, agreed processes for reviewing the services (preferably involving benchmarking provision against other service providers), reporting procedures and a robust mechanism for escalating and resolving problems. An outsourcing services contract is not a contract which should be put in a drawer once signed – it is a live and operational document.