On average, banks that outsource their information technology (IT) are substantially reducing costs. According to American Banker, banks are averaging savings of 15 to 20 percent in operational costs from outsourcing. First Fidelity Bancorp, which has $29 billion in assets, is a good example of a bank that has achieved considerable savings through outsourcing. The institution reduced their operating expenses by as much as $150 million in 1991, with the bulk of the savings derived from lower labor and equipment costs related to IT. But blindly pursuing outsourcing because it is what the company next door is doing, and doing well, is not necessarily a good decision, says Dr. Detmar Straub of Georgia State University.
“There are all kinds of reasons for outsourcing, but only some are rational,” Straub says. “The others are political and sometimes people are doing it to just be on the bandwagon because it is popular at the time or is a management fad.”
Straub, associate professor of information systems, says that many factors need to be considered when a business is considering outsourcing. And according to recent research of the U.S banking system by Straub and Soon Ang of Nanyang Technological University in Singapore, one factor in particular is not receiving the emphasis that it should — transaction costs.
The Impact of Transaction Costs
Transaction costs are the expenses that accrue from the time a company begins considering outsourcing through the managing of the contract once it is in place. These costs include the time and money that it takes to search for a viable vendor; to negotiate and write a contract; and to monitor and enforce service levels. “The decision to outsource involves a lot of people in the organization and a team of lawyers,” Straub says, “And as soon as I say to myself, ‘I want to see what outsourcing can do for my company,’ the expenses start building.”
According to Straub and Ang’s research, production cost (which is the amount of money a customer pays the vendor for its services) is given six times more emphasis than transaction costs. Production cost is a very important factor to consider, of course, because a company is looking to achieve a production cost advantage, which is the difference between what it costs to keep a specific function in house and what a vendor charges. But just as important are transaction costs, Straub says.
“Transaction costs should be just as valuable because they can be considerable and it can lead to disaster if companies don’t access these costs to make sure they are actually saving money,” Straub says. “Any production cost advantage that a business receives could be cut in half, nullified completely, or could potentially lead to a loss if transactions costs are higher than the production cost savings.”
Straub says that a lot of thought must go into transaction costs because these costs can sometimes be hidden. Take, for example, security costs. “It is difficult to classify which data and programs are supersensitive and which are not,” he says. “If you were to hire someone to handle security it would cost you so much to educate them in what was important that you might as well keep it in house. It’s difficult to see how there would be any cost advantage or strategic advantage to doing it.”
Cut Me Some Slack
A factor that received even less emphasis by the 243 banks that responded to Straub and Ang’s study was the importance of financial slack in the decision to outsource. Straub defines financial slack as excess financial resources above what is required to maintain the organization. If you are a very profitable firm you have a lot of slack, so you have a lot of extra resources to use as you choose. The smaller you are, by definition, the less slack you have in absolute terms. A small firm’s percentage of slack may be high, but in absolute terms they have less slack. So to a certain extent financial slack is correlated with size.
In previous literature it has been thought that companies with less financial slack look for ways to make or save money. Outsourcing has the potential to do both. First, a company can achieve a production cost advantage, as mentioned above. Second, by selling their assets to an outsourcer, a company gets a cash infusion. A good example of this is when General Dynamics sold their computers to its IT vendor. According to the Harvard Business Review General Dynamics sold their IT for $100 million because they were not doing well after the cold war ended.
Contrary to previous literature though, financial slack proved not to be a significant factor in the outsourcing decision process. “People were apparently not trying to get this one-time infusion of capital and that is good because firms have been criticized for having short-term business views,” Straub says.
In conclusion, Straub says that managers need to be attentive to the value of production and transaction costs in making an outsourcing decision. “It is a real challenge to estimate cost and savings when considering all the factors involved,” he says. “But in order to access the true value of an outsourcing decision, both transaction and production costs must be weighed in.”
According to the Association for Information Systems, Straub was the most prolific IS researcher in the world between the five year period from January 1990 to December 1994. He has published over 50 papers in many reputable journals. Currently his research interests include electronic commerce; computer ethics, security, audit and control; cross cultural IT studies and IT outsourcing. He has a DBA from Indiana University and a PhD in English from Penn State University. He is also a consultant in the areas of computer security and technological innovation and can be contacted at [email protected] Straub and Ang’s article titled Production and Transaction Economies and IS Outsourcing: A Study of the U.S. Banking Industry can be read in its entirety in MIS Quarterly volume 22, number 4, pages 535-552.
Lessons From the Outsourcing Primer
- Many factors need to be considered when making an outsourcing decision.
- One factor that is not getting enough attention by banks that outsource is transaction costs.
- Transaction costs should be given the same emphasis in an outsourcing decision as production costs.
- According to the study, financial slack was not a significant reason for outsourcing.