How to Calculate the True Costs of Sourcing Options

Creating a business-driven sourcing strategy is an important first step. But an apples-to-apples comparison of what it costs to insource a function versus outsourcing it must be fed into that framework. Outsourcers will always claim they can do better in terms of costs and service levels than internal IT - it's what they do - so building a case against outsourcing may hinge on fact-checking that claim. "You have to be able to say: 'Here are our actual costs and service levels. Here's what the provider can offer. Let's figure out what makes a good case'," says Gartner's Anderson.

Many IT organizations lack a true understanding of their internal costs and service levels. "For years, the business put money into IT because that was the cost of doing business. But now they're asking some hard questions," says Koulopoulos. "Unfortunately, the costs are often buried and there are no benchmarks."

Guesstimates won't do. To make a case for or against outsourcing an IT function, CIOs must know at a granular level how much their company spends on it internally. "You have to do it based on actual IT expenditures, not budget performance. Even labour costs at the macro level aren't good enough because one developer may be doing work in several different areas," says Harry Wallaesa, founder of IT consultancy The W Group.

Better, Faster and Cheaper at Vanguard

Jeff Dowds, IT principal, systems integration, who is in charge of delivering IT services for three of Vanguard's four lines of business, was always clear about the fact that the company's business strategy drives his IT sourcing decisions. But if you'd asked him two years ago about the service levels, costs and productivity of the mostly insourced IT department, he couldn't have told you. It was a tricky place to be for an IT executive overseeing an internal development staff of 1600, even as competitors were doing more and more outsourcing.

It's easy to see why IT went the do-it-yourself route at Vanguard. The mutual fund company operates virtually, and technology is the link between the business and the customers. "We wouldn't outsource all of our technology any more than we'd outsource our money management," Dowds says.

But one of Vanguard's strategic objectives is to keep costs low. If IT couldn't prove it was doing better than an outside provider, the decision to eschew outsourcing could come into question. "Delivering custom-built technology in-house is expensive and we pay a premium doing that work in-house and onshore. But we're always interested in being better, faster, cheaper," says Dowds.

In 2004, Dowds started to laser in on costs and quality metrics. He knew he was probably paying a premium to keep development in-house and needed to validate that investment with returns like developer productivity and software quality. But "it was a struggle to figure out how to best measure it and get the accounting right", says Dowds. "We have to do it a consistent way to justify our choice to keep development in-house."

As for costs, he says, "we don't cost account ourselves to death". For each project, Dowds multiplies the hourly cost for developers times the number of developer-hours required and tacks on an additional 15 percent for infrastructure costs (say, additional Unix processing horsepower or increased storage) and another 15 percent for the businesspeople who work with IT on the project. "I don't want to say it's precise," says Dowds, "but it works well."

The data has enabled IT to justify its sourcing decisions to the business and stave off pressure to offshore application development. "IT is the biggest cost to the business and we don't get a free pass," says Dowds. "We have a Vanguard governance group at the most senior level and they will challenge IT on how it sources development. We have been able to show them what our costs and productivity are and how we can manage them better. Outsourcing is not the only way to drive IT costs down. We can be more efficient and more productive."

When it comes to outsourcing, Dowds would never say never, though. Ten years ago, Vanguard outsourced its LAN administration in order to cut costs. Four years ago, Dowds brought that work back in-house for the same reason. In both cases, the sourcing decision achieved the desired effect. "If we discovered that our competitors were substantially lowering their costs by outsourcing and closing the gap in a material way, we'd have to re-examine our decision," he says.

Meanwhile, Dowds displays fiscal responsibility by employing cheaper contract labour (which usually amounts to 8 percent of IT's total labour pool) that he can shed when times get tougher. "That way, [the business] is not asking: 'When is IT going to wake up and outsource like everyone else?'" Dowds says. Thus far, there hasn't been a case where insourcing development was so expensive or counterproductive that Dowds couldn't build a business case for it.

"You don't ever want to get yourself into a position where you have to outsource because you're not good at what you do," says Dowds. "You do it because there are other reasons in the business that drive you there."