IT Outsourcing Trends: Slow Growth, Cloud Computing

Despite predictions to the contrary, IT outsourcing has contracted rather than expanded in the years since we entered the Great Recession, according to industry watchers. That shows signs of changing in 2010, but analysts forecast that IT outsourcing growth will remain slow for some time to come.

“Most companies in most of the categories we track are only partially outsourcing a function,” said John Longwell, vice president of research at research firm Computer Economics. “Most of them are using outsourcing to fill in around the edges. A lot of those companies went back to reviewing and reducing their outsourcing [when the recession began]. The general trend was that companies were taking it back in house.”

“When you look at areas like applications development, just the drop off in capital spending and investment in new systems is going to cause a reduction in that sort of outsourcing,” Longwell added. “A lot of people renegotiated their contracts and a lot of people dropped their services and brought those functions in house. As we’re coming out of the recession, that trend is going to reverse itself.”

IT consultancy EquaTerra said that more than 75 percent of the service providers it polled in the third quarter of 2009 reported continued growth in their deal pipeline, which was up 10 percent from the previous quarter and 34 percent from the same period year-over-year.

Technology Partners International (TPI) echoed that sentiment. The most recent Global TPI Index indicated that the IT outsourcing market’s total contract value in the fourth quarter of 2009 reached $19 billion, the highest quarterly total in six years.

To put it plainly, 2009 was the year of IT outsourcing deal renegotiation.

“One of the dominant features of the outsourcing market over the last 12 to 15 months has been the emphasis on cost above all else,” noted research firm Morrison & Foerster in a report on IT outsourcing trends in January. “We have always believed that cost was (and remains) the primary driver in most outsourcing transactions. The difference is that during the boom years of 2002-2008, cost was often down-played by customers and, instead, emphasis was placed on other business benefits such as transformation, concentrating on core competencies, and speed to market. 2009 saw cost and, more particularly, immediate cost savings, take center stage when customers engaged with existing suppliers or contemplated new sourcing projects.”

The analysts explained that this is why so many outsourcing contracts were renegotiated in 2009, with suppliers asked to share some of the pain of their customers. The renegotiations primarily took the form of reductions in pricing, relaxation of volume commitments and service levels, and bringing forward the financial benefits of transformation projects.

“Service providers often felt they had no choice but to agree to these changes and, often, it was better to keep an existing customer happy even at the cost of margin dilution,” the Morrison & Foerster analysts wrote. “The main other benefits for service providers came in the form of contract extensions and renewals and the ability to show investors that the service provider’s revenues were secure despite the overall financial turmoil in the markets.”

Capital intensive forms of IT outsourcing, like application development — far and away the most common form of IT outsourcing — were hit especially hard, as businesses put those projects on hold, according to Computer Economics’ Longwell. Application maintenance saw a similar story.

Future of IT Outsourcing

So what does the future hold? That depends on where you’re doing business.

Morrison & Foerster noted that economists are now talking about a “LUV” recovery from the recession, with the letters representing the “shape” of the recovery: a very slow L-shaped recovery for Western Europe; a slower U-shaped recovery for North America; and a rapid V-shaped recovery for Brazil, Russia, India, China and other emerging economies.

KPMG and the Asian-Oceanian Computing Industry have forecast that Asia will account for 26.3% of the total consumption of IT and BPO services in the next 10 years.

In the realm of IT outsourcing, Morrison & Foerster said a rapid V-shaped recovery for the latter set of countries may encourage further spending on offshore outsourcing. In turn, that means service providers will have to carefully consider how to price new transactions in light of the “twin threats of cloud computing and continuing labor cost arbitrage.” And, if parts of the world economy move at different speeds over the next 12 months, Morrison & Foerster said service providers will need to consider more varied pricing strategies.

Agility and Flexibility

Flexibility will be the watchword in outsourcing deals in 2010, according to Morrison & Foerster.

“In 2010, we see a continuation of the trend for shorter deals, shorter procurement processes, and an emphasis on making things work rather than engaging in complex strategies,” the analysts said.

This is likely to lead many firms to take their IT services procurement in-house—so-called DIY sourcing. Yet Morrison & Foerster predicted that will be a mistake for many firms.

“While the DIY approach will often result in short-term transactional cost savings, inexperienced purchasers of outsourcing services usually suffer longer-term losses because they fail to identify many of the key components for long-term success. For example, with the increased focus on costs, buyers will try and save on governance costs and overlook necessary governance functions. Particularly when customers engage in multisourcing transactions, heightened attention to governance processes is critical. As a result, we believe that many of the raft of 2009/10 deals will run into problems because they have not been properly managed by customers.”

IT Outsourcing Verticals

As the recovery gets underway, banks and insurance companies – which were among the hardest hit verticals of the recession and which put more deals on hold in 2009 than other sectors — are likely to come back to the fold in 2010, particularly toward the second half, according to Morrison & Foerster.

The firm predicted increased activity in other verticals as well, including hospitality and healthcare, with healthcare reform in the US particularly driving the latter.

Cloud Computing and IT Outsourcing

Cloud computing is likely to take center stage in IT outsourcing in 2010, according to experts.

“2010 will be the first year in which cloud computing will have a real role in procurement decisions,” Morrison & Foerster said. “To be sure, cloud providers must deal with the key issues of data security, privacy compliance and service level guarantees, but the market potential is too great for solutions to these problems not to be forthcoming.”

The analysts noted they expect the outsourcing industry to begin seriously addressing these issues in 2010. That means cloud solutions will become an acceptable risk for customers. At the very least, the dramatically lowered cost of cloud providers will become a lever for customers to use in negotiations with their traditional sourcing providers.

Cloud computing is also likely to simplify the contracting process, Morrison & Foerster said, putting the focus on due diligence regarding the provider’s solution rather than the development of detailed contractual language. In addition, cloud is likely to create new options for combining process, software and hardware in business process outsourcing (BPO) solutions.