from cost management to innovation and business value

Outsourcing:FROM COST MANAGEMENT TO

INNOVATION AND BUSINESS VALUE

Michael R. WeeksDavid Feeny

D uring the past few years, innovation has become a headlineagenda item for many firms1 and for their CIOs.2 Can CIOs whohave outsourced most of their information technology (IT) meetthe challenge, or is outsourcing incompatible with innovation?

Certainly, losing innovative capabilities is recognized as a potential risk of out-sourcing in these environments.3

IT outsourcing is now twenty years old and many large organizationshave a decade or more of experience in large-scale IT outsourcing relationships.For these firms, the success of their relationships is critical, since switching sup-pliers is extremely costly and painful, and a large-scale return to in-sourcedalternatives is seen to be almost impossible. “Success” is a multi-dimensionalconcept: the most obvious goals are to achieve high-quality IT services at lowlevels of cost; but the rhetoric of IT outsourcing has included an expectation thata “world-class strategic partner” will also be a source of new ideas and practices,leading to increased business value over time.4 It is in these dimensions of inno-vation and “added value” that firms have most commonly been disappointed.Consequently, our research has focused on how improved innovation outcomescan be achieved.

Interpretation of prior research work does not suggest definitive conclu-sions about the effect of IT outsourcing on innovation.5 Clearly, external per-spectives and skills may contribute to innovation potential. However, increasedcoordination complexities and a lack of alignment of risks and incentives maymake achievement of the potential more difficult. Our expectation was that IToutsourcing in itself neither ensures nor negates innovation. Outcomes will bedependent on key enabling factors within the relationship, which the researchset out to identify.

127CALIFORNIA MANAGEMENT REVIEW VOL. 50, NO. 4 SUMMER 2008 CMR.BERKELEY.EDU

The Scope of the Research

Our research included four in-depth case studies, all involving large firmsin long-term relationships with prominent providers of IT outsourcing services.

Case 1

Client firm A is a leading engineering company, increasingly focused ondefense markets. It has annual revenues of more than $20 billion and extensiveoperations in both the USA and Europe. Client A took the decision to outsourcemost of its IT activity in 1993. It was a decision taken by the highest-level GroupExecutives who were unconvinced that IT was a core competence and saw thatoutsourcing would provide an immediate and much needed improvement to thebalance sheet. They also hoped that it would result in lower IT costs over time.Their chosen provider was Supplier X, itself a major firm with current revenuesof more than $15 billion and an extensive client base across many geographiesand industry sectors. Supplier X took on the great majority of Client A’s IT oper-ations—and 85% of its IT staff—in 1994, and remains Client A’s provider to this

day. However, the relationship haspassed through a number of moods andphases, and two contract renegotiations.The first of these, in 1996, sought torealign the contract to client businessobjectives after an initial period markedby adversarial debates around contractterms and expectations. The second

renegotiation, in 2000, was triggered by substantial changes in Client A’s busi-ness configuration following major M&A activity. The opportunity was taken in2000 to more formally express Client A’s expectation of an innovation contribu-tion from Supplier X—an expectation that had been present from the start, butwas not being met to Client A’s satisfaction. Two years later, however, a down-turn in market conditions led to new pressures from Client A to reduce IT costlevels beyond the contract terms; and there was continuing ambiguity observedin Client A’s view of the role and significance of IT, particularly at strategic busi-ness unit (SBU) level. Nevertheless, Supplier X’s revenues from the relationshiphad grown from around $200 million in 1994 to more than $750 million, andClient A was reported to be the company’s largest single customer.

Case 2

The second case study involved a leading manufacturing concern and itsrelationship with another of the major providers of IT outsourcing services.Client B specializes in gas turbine technology for aviation and marine applica-tions, and it has annual revenues of around $12 billion. Its IT outsourcing expe-rience started in 1996 when its largest single business division transferred almostall of its IT activity and staff to Supplier Y—an IT services firm with revenues ofaround $10 billion—in a contract worth around $125 million per annum. As inCase 1, balance sheet benefits from the transfer were again significant in the

Outsourcing: From Cost Management to Innovation and Business Value

UNIVERSITY OF CALIFORNIA, BERKELEY VOL. 50, NO. 4 SUMMER 2008 CMR.BERKELEY.EDU128

Michael R. Weeks is an Assistant Professor ofManagement in the Sykes College of Business at theUniversity of Tampa. <[email protected]>

David Feeny is the Director of the Oxford Institute ofInformation Management and a Fellow of TempletonCollege and the Saïd Business School of theUniversity of Oxford. <[email protected]>

decision making. By the middle of the current decade Supplier Y’s business withClient B was worth around $400 million per annum, and they provided IT ser-vices to all of Client B’s business divisions. However, the relationship had beenon something of a rollercoaster ride. Both parties agreed that it started well.Supplier Y involved its consultancy arm, which operated across its eight ClientIndustry Divisions, in a series of business process improvement projects thatdelivered early benefits to Client B. However, by 2000 it was judged that thetechnology infrastructure planned to support new business processes was mis-aligned with the reality of pressures on Client B’s IT cost structure. A renegoti-ated contract in 2000 provided Client B with further short-term financialbenefits, and Supplier Y with a contract extension. It also included mutual com-mitment to a significant reduction in unit costs through rationalization of theinfrastructure, a project that led a year later to a further crisis when Supplier Yclaimed that Client B was failing to deliver on the company-wide standardiza-tion on which such rationalization depended. At the time of the research inter-views, the outlook for the relationship was in the balance, with recent changesto the leadership of Supplier Y’s account team intended to restore a positiveclimate.

Case 3

There are a number of parallels between Case 3 and Case 1. Client C isalso a prominent engineering group with an emphasis on defense markets; itstarted to outsource its IT activity in 1991; and its chosen long-term provider isalso Supplier X (as in Case 1), although the client firm headquarters (and thecentral relationships) are on opposite sides of the Atlantic. One of the relevantdifferences is that Client C had a strategic rather than financial rationale for out-sourcing IT. Foreseeing a period of major uncertainty in its markets at the end ofthe Cold War, Client C wanted to increase its agility by de-coupling IT operationsfrom a particular business configuration. This did not signal a belief that IT wasunimportant to the business; in fact, retained IT managers report at more seniorGroup and Division levels in Client C than they do in either Client A or B. More-over, although they continue to employ fewer of their own IT staff than ClientA, it is markedly more than in Client B. A further contrast with the first twocases is that Client C models its relationship with Supplier X on the wider orga-nizational norms of the business: an enabling umbrella contract with Supplier Xis held by the Group CIO; and business divisions have their traditional obligationto pay attention to the center’s lead, but the right not to follow it. In practice, alldivisions do use Supplier X, but through specific contracts that each has negoti-ated for itself. Overall, Supplier X achieves annual revenues of roughly $220million from Client C, and the relationship seems to have avoided the crisesdescribed in the previous cases. Although we examined the overall relationshipbetween Client C and Supplier X, our primary focus for this case study wasClient C’s submarine manufacturing division in the northeastern U.S.


CALIFORNIA MANAGEMENT REVIEW VOL. 50, NO. 4 SUMMER 2008 CMR.BERKELEY.EDU 129

Case 4

Our fourth case study is rather different. Client D is one of the majorpharmaceutical firms, with annual revenues in excess of $18 billion. It is anextensive user of IT and retains 2500 IT staff—choosing to outsource only ITinfrastructure (excluding software development). Until 2000, it had taken nomajor IT outsourcing initiatives within an overall IT infrastructure budget ofapproximately $160 million. Its decision in 2000 to outsource its IT infrastruc-ture was driven by a desire to improve the quality and integrity of a fragmentedasset base (partly inherited through merger activity) and by a perception thatthis could best be achieved through an expert external firm while internalresources focused on development of innovation-oriented applications. The cho-sen provider was Supplier Z, one of the large IT sector firms that have increas-ingly diversified from hardware and software products into the provision of ITservices during the past decade. As a product provider, Supplier Z was alreadywell known to Client D. Both sides emphasized a spirit of partnership and a codeof behavior to support the new relationship, and a carefully structured contractprotected Supplier Z from early short-term cost pressures. At the time of theresearch, this comparatively younger relationship was encountering issues buthad avoided any major crises.

The Innovation Quest

What all four case studies have in common is that they were seekinginnovation—broadly defined as improved business outcomes for the clientfirm—through changes in which the supplier firm would be a principle actor. InCase 4 the domain of change for the supplier firm was clearly bounded; in theother three cases the supplier firm had much broader scope within which topropose and pursue change.

Research interviews soon identified that, while innovation was the com-mon rhetoric and quest, there was wide variation in views as to what qualified.Supplier representatives frequently suggested examples of new technology capa-bilities as innovation, while client executives were more concerned with busi-ness process change or the introduction of new services. Within each case study,we identified a number of specific innovation initiatives to be researched indetail with those involved, and we classified them within the taxonomy depictedin Figure 1 (to which all participants could readily relate).

Overall we positioned innovation as the introduction of strategies, busi-ness processes, or technologies that are new to the relationship and are intendedand expected to lead to new business outcomes. Such development initiativesdid not necessarily have to be new to the entire world, only to the environmentunder study. Within the model:

▪ IT Operational innovations were defined as developments that involvetechnology changes not impacting firm-specific business processes. Thesemight include new operating systems, new e-mail platforms, or hardwaresuch as printing and imaging devices. Clearly such innovations were



unlikely to directly producenew business outcomes, butthey qualified if pursuedwith the expectation thatthey enabled new andsuperior ways of exploitingIT, which would in turnenable business improve-ments to be achieved.

▪ Business Process innovations,by contrast, do change theway the business operatesin some important ways.Innovations in this areamay include introduction ofnew technologies such asRFID devices or enterpriseresource planning (ERP) software, but only if deployed in a way that fun-damentally alters the working processes of the organization.

▪ Strategic innovations were defined as those that significantly enhance thefirm’s product/service offerings for existing target customers, or enablethe firm to enter new markets.

The definitions thus reflect a client rather than supplier orientation (forexample, a new help desk structure might be considered a business process inno-vation by an IT supplier, but it would be considered as at best an IT operationalinnovation by most outsourcing customers and categorized as such in our work).

Apart from more general investigation of innovation objectives and expe-rience in each case, we studied in more detail the stories of nine specific exam-ples of innovation efforts. Our interests in each were to understand client andsupplier involvement in the origins of the idea and how it was evaluated; in theway pursuit of the initiative was planned and developed; in implementationaction; and in evaluation of outcomes and supportive evidence.

▪ Case 1 provided four of the examples of innovation initiatives. Two wereclassified as IT operational changes, each offering substantive new capabili-ties and both successfully implemented. One initiative was in the businessprocess category, and was also implemented successfully. The fourth initia-tive was a significant attempt at a strategic innovation, but it was notachieved.

▪ Case 2 included two initiatives. While both were in the IT operational cate-gory, they each required very substantial financial and human resources.One was successful and did indeed enable managers in Client B to subse-quently achieve new levels of business operational performance. Theother initiative was not successful.



FIGURE 1. Categories of Innovation

Strategic

Business Process

IT Operational

▪ Case 3 represented the richest ground for innovation study, with almostone hundred innovation projects—large and small—being pursued underthe auspices of a joint Client C/ Supplier X Review Board. We focused theresearch in this case on the innovation process as a whole, but with par-ticular attention to a successful innovation in the strategic category.

▪ Case 4, by contrast, was looking only for IT operational-level innovationswithin its outsourcing relationship. We studied two initiatives in this cate-gory, one of them having achieved success while the other was in theprocess of addressing significant difficulties.

Innovations can indeed be achieved within an IT outsourcing relation-ship, but (not surprisingly) most of the examples we found were at the IT opera-tional level. Even at this level, failures seemed to be explained more by the IToutsourcing context than by mistaken goals or lack of professional implementa-tion effort. The relative scarcity of the higher-level innovation outcomes of par-ticular interest to our client interviewees further underlines the importance ofunderstanding the particular challenges that an IT outsourcing context may pre-sent. Since that context clearly varies over “time and tide,” our analysis startswith insights to be gained from a life-cycle perspective on IT outsourcing rela-tionships.

The IT Outsourcing Learning Curve

Why is it so difficult to achieve innovation within outsourcing relation-ships? Clearly, effective partnerships and the innovation they may produce donot develop overnight. Our case study research companies broadly traced thethree-stage learning journey described elsewhere by Rottman and Lacity, whichis characterized by successive focuses on cost, quality, and the new businessvalue that innovation can provide.6 Furthermore, it became clear that decisionsmade during the first two stages can have unintended implications for successchances in the third. To illustrate, Table 1 provides an adaptation of Rottman andLacity’s original model from which we can draw relevant highlights from ourcase studies. While we are clear that innovation performance is driven by certainenablers rather than by evolution, the presence or absence of those enablersmay be explained by the way client and supplier firms have reacted to earlier,“pre-innovation” challenges.

The Cost Focus Stage

In many longstanding relationships (including our first two case studies),IT outsourcing started with a perception at the top corporate executive level thatthe IT function and activity represented a “non-core” part of their business, a“commodity” whose cost should be minimized by external firms who were spe-cialists in IT.7 Contracts were awarded on that basis and sponsoring executiveswere gratified by the evidence from competitive bids that their IT costs couldindeed be reduced by 20% or more.8 For future innovation purposes, the poten-tial dangers encountered in this stage are fourfold:



▪ Most (sometimes virtually all) of the employees who represent the tech-nology know-how of the client firm are transferred to the supplier, whosebusiness it now is to understand IT. This has ongoing implications for thelevels of dialogue in which the client and supplier can engage and, conse-quently, for the levels of trust.

▪ The devolution of strategic business unit IT-related decision making,which has typically been a feature of multi-business firms, is now sharplyreversed as power comes to reside at the corporate center with the execu-tive who owns the central contract with the supplier. This limits the free-dom to maneuver within business units and reduces their inclination toinvest in innovations that require a significant IT component.

▪ A clear signal is given to SBU executives that IT is positioned as non-core/commodity, and that it is not therefore expected to feature signifi-cantly in their key business decisions. This reduces the chances that ITmanagers within business units will have the involvement and influencerequired to engage in innovations beyond the IT operational level.

▪ The winning supplier firm now faces the challenge of achieving contractprofitability despite an unremitting client pressure on cost and an inheri-tance that often included outdated technology and inappropriate staffinglevels. The client-supplier relationship becomes dominated by constantnegotiation around the contract and what it included in terms of scopeand agreed pricing. A zero-sum game is played out, with suppliers poten-tially experiencing the “Winner’s Curse,” which results when the pricerequired to win a contract is so low that the successful bidder cannot pos-sibly make a profit.9 Such a low-trust buyer-supplier relationship is farremoved from the ecology required for innovation.

In our cases, Client B experienced all four of these negative effects andClient A all except the first. The longer-term consequences can be seen in bothcases. The more strategic approach to IT outsourcing of Client C, however, pro-tected it from all four dangers; and Client D with its focused entry into IT out-sourcing sought to circumvent this stage altogether.



TABLE 1. Characteristics of the IT Outsourcing Learning Curve

Cost Focus Quality Focus Innovation Focus

Client Concerns IT as Commodity IT Underpins Business IT is Potential EnablerCritical Activity of New Business Value

Supplier Concerns Contract Profitability Platform Development Partnership Development

Relationship Focus Constant Negotiation Best Practice IT Exploration/Ideas

Target Outcomes Cheaper IT Better IT Better Business

The Quality Focus Stage

Usually a number of factors combine to drive a second-stage redefinitionof the relationship, of which the two most important are a shared dissatisfactionwith the first stage and a growing realization in the wider firm that some of theIT activity is underpinning what are business critical activities. The emphasisnow moves to ideas such as “fitness for purpose” (the “right” level of servicequality) and, while cost is still important, the metric is “value for money” withclient firms accepting that it is in their own interests to reward supplier compe-tence with “fair” returns. The 1996 contract renegotiation between Client A andSupplier X and that between Client B and Supplier Y in 2000 mark their con-scious decisions to move to this stage; and the quality-before-costs terms ofClient D’s contract with Supplier Z are aligned with the intention to make aStage 2 entry. While the drivers of Stage 1 are antithetical to innovation aspira-tions, the objectives of the Quality Focus Stage promote a number of develop-ments that were helpful to our case study firms’ subsequent aspirations forinnovation, as well as their successful navigation of Stage 2:

▪ A quality objective requires both client IT and supplier managers to re-invest in business orientation in order to understand what fitness for pur-pose looks like. When this is combined with the goodwill generated byservice quality improvements, it can substantially improve business sideconfidence in their internal and external IT providers, and it canstrengthen business/IT relationships.

▪ Client firms are prompted to take a harder look at the IT capabilities theyshould retain, how their own IT staff can build a convincing understand-ing of the business’s IT needs and then complement rather than duplicatethe efforts of the supplier in meeting them.

▪ With increased confidence in the future of the relationship, the suppliercan reconsider investment for the future. What platform will be requiredto deliver the service quality, consistency, and robustness over time? Howcan it be financed and achieved? Client D accepted that its IT unit costswould actually increase significantly over several years as Supplier Z builtthe new infrastructure seen as appropriate to meet rigorous regulatoryrequirements in its various global pharmaceutical markets.

▪ This example points to what is now a critical discussion within the rela-tionship: what defines “good” supplier performance, and what is a “fair”reward for achieving it? Answering this question requires moving beyondthe contract to understand what constitutes “current best practice” in theIT outsourcing marketplace—especially for the client firm. Externalbenchmark data becomes central to discussion between the parties; withtrust established by decisions that are seen to be grounded in that data.

By 2000, Client A/Supplier X and Client C/Supplier X were seen to haveachieved the objectives of Stage 2 with mutual confidence in the quality of ser-vice provided and the cost levels at which it was being achieved. In Case 2, theClient B/Supplier Y relationship struggled to achieve the Stage 2 objectives andthey were regularly in danger of regressing to an adversarial focus on cost. Nev-



ertheless, the examples in Case 1 and Case 3 show that important innovations atthe IT operational level can be achieved during this stage. Business process- andstrategic-level innovations require further capability.

The Innovation Focus Stage

A general weakness of life-cycle models is that they suggest an orderlyand sequential progress through a series of stages. Real life is, of course, morecomplex, and we have already seen that in Case 2 the client-supplier relation-ship oscillated between stages. In a further example, Client A and Supplier X inCase 1 became confident by 2000 that they were ready for a new focus on inno-vation; only to find that changes in the wider business context required them torevisit the issues of earlier stages.

Our work takes a long view of the IT outsourcing life cycle. The model isadditive rather than sequential, with progress in any stage taking place in paral-lel with sustained attention to the requirements of previous stages. Our frame-work examines the requirements—rather than the aspirations—of a “final” stagefocused on added business value through innovation. Overall, our research iden-tified nine key enablers of innovation, covering aspects of client capability, sup-plier capability, and relationship readiness.

Understanding the Key Enablers of Innovation in Outsourcing Relationships

Our research started with a study of previous literature on outsourcingand inter-organizational relationships.10 While the learning curve model pro-vided interesting insights, the many phenomena that emerged during the courseof the research required additional framing to better explain the processes andoutcomes we observed. Our case studies highlighted a subset of the existingliterature’s relationship factors as having a significant bearing on innovationoutcomes, together with some additional factors extant in other threads of thelarger body of work on innovation. Figure 2 shows the full set of identifiedenablers, separated into client, supplier, and relationship enablers.

The Client Enablers

Technology Knowledge

Academics who have researched the challenge of innovation with exter-nal partners have identified the importance of having a common base of “priorrelated knowledge” between the partners, the bridging knowledge necessary forthe transfer of ideas. This concept is called “absorptive capacity” by Cohen andLevinthal.11 For our purposes, this absorptive capacity translates into the impor-tance of an excellent technology knowledge base within the IT function of theclient and requires the employment of a number of highly skilled technologyexperts who disseminate their understandings through the wider organization inthe unique organizational context of the client.



Companies that had been through a Stage 1 outsourcing experience hadgenerally not catered for this requirement, concentrating their retained IT onresponsibilities related to managing the suppliers and communicating with thebusiness. These companies were rebuilding their in-house IT expertise duringStage 2, albeit for the different purpose of creating effective dialogue with theirsupplier in pursuit of high-quality service. Client B had downsized its pool sodramatically that the firm felt that it could no longer effectively communicatewith its supplier. The Director of E-commerce for Client B commented:

“We’re pretty un-intelligent as customers. And I think that’s one of our weak-nesses. We’ve got to think about, have we got the boundary in the right place?”

Client A was also struggling with the right balance of technical versus businessprocess knowledge. A divisional CIO for Client A said:

“I don’t need technicians; I need business people. I’ve got technicians. There’s arole for both. I need to blend the technical expertise of Supplier X with the busi-ness requirement of [our firm]. I need to have enough knowledge in the people Ihave, so just from a technical standpoint, we know we’re not getting sold a bill ofgoods.”

On the other hand, Client D never reduced its technical skills pool. Thefirm maintained a large technical contingent for software development; how-ever, these technical personnel frequently encroached upon Supplier Z’s terri-



FIGURE 2. Achieving Innovation in an IT Outsourcing Relationship

Relationship Enablers• Innovation Governance

• Trust• Measurement Specificity

IT Supplier Enablers• Business Process Skills

• Industry Scope

Client Enablers• Technology Skills

• Selective Sourcing Mindset• IT Organizational Alignment

• IT Leadership

Strategic

Business Process

IT Operational

INNOVATION OUTCOMES

tory in hardware and services. The supplier felt that Client D was stifling thepotential creativity of Supplier Z by over-specifying needs and micro-managing.The “Goldilocks Principle” applies it seems—too many is no better than too few.

Client C seemed to achieve the best balance of technical and businessknowledge, but this was due to the maturity of the relationship and a consciousdecision to develop certain competencies. The divisional CIO for the submarinedivision points out:

“The relationship has evolved, and we have some new people in here. We had todo some resetting of expectations along the line here. In addition to skills in theirrespective [technical] fields, whether that is application development or infra-structure, the knowledge of the business is key for me.”

Selective Sourcing Mindset

When selective sourcing was first discussed, it referred to the strategy ofseeking best of breed IT suppliers for each distinct IT area of activity. Firms suchas BP pioneered this approach in the mid-1990s.12 Our findings expand this ideato the concept of a selective sourcing mindset rather than a specific use of multi-ple suppliers. In fact, all of our case studies used a single supplier for their out-sourcing relationship. A selective sourcing mindset recognizes that IT is aportfolio of activities and a firm should not have a homogenous structure thatconstrains all aspects of its IT outsourcing relationship. Not only do various ITactivities require different treatment within the relationship, different businessunits within the firm may have distinctive definitions of success as well aswidely varying acceptance criteria for deeming a technology initiative “fit forpurpose.”

A good example is the approach taken by Client C. This diversified firmhas business units ranging from a builder of submarines to a corporate jet manu-facturer. Client C has a preferred supplier, but its business units are free to nego-tiate their own contracts. The Client C CIO (now retired), described the mindset:

“Whereas with many other companies the deal is done at the corporate level andeverybody has to live with it, we have an umbrella agreement that has generalterms and conditions. Each business unit is under that umbrella. But when theyoutsource, they do their own deal. I don’t negotiate a deal for them. I introducethe parties and I act as referee to make sure the deal is fair.”

Two of the other case studies also demonstrated a willingness to considermultiple approaches to sourcing IT. Client D retained a large in-sourced opera-tion for software application development and Client A was exploring a selectivesourcing arrangement for its upcoming contract renewal. Only Client B seemedinextricably wedded to its IT supplier, and this was despite significant relationalturmoil. While the poor results at Client B could not be explained solely by alack of a selective sourcing mindset, certainly the inability to consider alternativesourcing arrangements contributed to the stagnant relational environment.

While the use of multiple suppliers may promote innovation throughaccess to a wider set of ideas, the selective sourcing mindset is the real key. The



importance of this enabler emerges in a Stage 2 relationship as the mindsetallows client and supplier to recognize a range of solutions as “fit for purpose.”When the attention of the firm shifts to business-level innovations and theirdistinctive characteristics, this mindset becomes essential.

A Match between Client IT and Corporate Structure

Alignment between IT and the business organization in a “federal” modelhas long been accepted wisdom.13 A federal IT organization provides the oppor-tunity to agree on centralization of IT activities that benefit from scaleeconomies, alongside the flexibility to respond to needs of business units acrossthe firm (as demonstrated in Case 3). As noted, this alignment was frequentlybroken at the start of outsourcing relationships by the effective centralization ofIT through a contract that was corporately inspired and managed. This situationoccurred in Case 2. The firm was multi-divisional and federal, but the outsourc-ing agreement was managed centrally.

To achieve innovation outcomes that go beyond the IT operational, align-ment needs to be rebuilt. If business leaders are to take the risks implied by busi-ness process- and strategic-level innovations, it is understandable that they wantthe IT components of those innovations directed by IT staff whose understand-ing of and loyalty to their business agendas is clear.

Executive-Level IT Leadership

Strongly related to the need for IT organizational alignment is executive-level leadership of IT. Whatever the formal nomenclature (CIO, IT Director), theterm refers to an IT leader who sits one or two levels below the business CEO inthe organizational structure, who has regular access to the CEO and other keyplayers, and who is regarded by them as an important member of the businessteam. Again, this is not a new idea in the context of exploiting IT for businessvalue,14 but it is an idea that often needs to be re-examined within the contextof outsourced IT.

The direct need is to establish or re-establish excellent relationshipsbetween CEOs and IT Leaders within the business units where innovation initia-tives are being promoted. However, we found that firms struggled to get thisenabler in place at business unit level if a different situation exists at corporatelevel. As one frustrated IT executive at business unit level for Client B explainedto us:

“Our Corporate CIO is five layers down in the organization. And this is a part ofthe problem—our company does not have, in my view, at the enterprise level, thevision of what IT means to their business. They don’t understand it to the extentthey’re willing to change their organization structure and their operating model toreflect IT’s importance to the firm.”

Having executive-level IT leadership at the corporate level both signalsthe desirability of having it at the business unit level and provides an informedand supportive review capability for innovation proposals. Executive-level IT



leadership is required at both corporate and business unit levels of the clientfirm, and one cannot sustainably exist without the other.

The IT Supplier Enablers

As we now discuss innovation enablers required in the supplier, we takefor granted some “basics.” Specifically, we assume that the supplier possesses thetechnical and management skills required to convincingly deliver whatever arethe existing services under contract. They may well in addition haveimplemented innovations at the IT operational level. Our concern here is todescribe the additional capabilities required to help the client achieve higher-level innovation outcomes.

Business Process Design Knowledge

Business process design knowledge represents the “prior related knowl-edge” (the absorptive capacity) required in a supplier who can partner in thepursuit of higher-level innovation outcomes. It is the mirror image of the client-side requirement for retention of “technical knowledge.” In a relationship thatoriginated with a Stage 1 cost focus, the supplier may well have inherited someknowledge of client business processes through the transfer of some of theclient’s IT staff. However, this knowledge may have atrophied during a period ofcost reduction, and in any case does not imply the design knowledge compo-nent. The requirement is for the supplier to develop extensive knowledge ofclient business processes and to be able to contribute to discussions and subse-quent action plans targeted at their improvement. This represents a consciousup-front investment of resources by the supplier, but one that may be easier tomake if the client and supplier are working together in “fair returns” modewithin the longer-term perspective of a Stage 2 period of quality focus.

Client-Industry Scope of the Supplier

The depth and breadth of the supplier firm’s relationships with otherclient firms and industries is a determinant of what external knowledge theymay bring to innovation initiatives. Suppliers with depth (multiple relationships)in a client’s industry may have previously encountered specific challenges thatthe client faces. Suppliers with exposure to clients in a wider variety of indus-tries are assumed to be able to deliver radical ideas from these disparate sources.The clients in our study tended to benefit more from suppliers with industrydepth, rather than industry breadth. For example, a significant innovation at thebusiness process level involved the transfer of submarine manufacturing controlprocesses from Client C to Client A. The IT supplier had two clients in this indus-try, Client A and Client C. The British firm adopted the control process devisedby the American firm at the prompting of the IT supplier and a divisional CIOfor Client A, who demonstrated the business process knowledge required toimplement the advanced systems on which the new processes were based.

While we did not encounter significant innovations that used the breadthof a supplier’s client base to the benefit of our research participants, this is not



unexpected as it represents higher levels of challenge and risk. Nevertheless, asfirms grow their experience and confidence in innovation within relationships,some “cross industry” examples of transfer may be expected in future.

The Relationship Enablers

The final element in our model identifies the way in which the client-supplier relationship must grow to achieve innovation outcomes. We identifiedthree enablers in this element. Two of them—trust and measurementspecificity—will probably have been developed in a Stage 2 context. The third—innovation governance—is very specific to the Stage 3 focus on innovation andthe creation of new business value.

High Levels of Trust

Trust within an outsourcing relationship is a factor at work even beforethe outsourcing contract is signed. One might expect that the typical negotiationprocess would be harmful to trust, but previous research, as well as our study,found that firms are likely to start a relationship with high levels of trust sincethey have mutually concluded a successful contract negotiation phase.15

To understand the complexities of the trust environment, we reviewedmodels of trust in a wide range of contexts.16 We developed a three-prongedmodel of trust that reflected the complexities of the outsourcing environment:personal trust, competence-based trust, and motivational trust. These elementsilluminate the fundamental tensions in even the best outsourcing relationships.

▪ Personal trust refers to the confidence one has that another person willwork for the good of the relationship based on their integrity and adher-ence to moral norms. Cross-cultural relationships can complicate one’sunderstanding of “moral norms,” but generally researchers have foundthat people are surprisingly willing to trust one another until that trusthas been violated.17 The uncertainty inherent in innovation efforts addsanother element to personal trust. Namely, when things go wrong, whowill suffer the consequences? In relationships with high personal trustthere is an understanding that all parties will accept responsibility for risksthat do not work out, rather than “pointing fingers” or deflecting blame.

▪ Competence-based trust exists when one party has confidence that the otherwill successfully deliver their allocated tasks and responsibilities. Success-ful completion of projects and achievement of joint goals will enhancecompetence-based trust, while operational failures will degrade it. Thefact that a supplier wins the initial negotiations surrounding the outsourc-ing contract typically creates goodwill for the very early phases of therelationship. However, when operational problems are encountered (thenorm in Stage 1), the competence-based trust starts to erode. As relation-ships move into Stage 2, the focus on quality provides the opportunity toimprove this type of trust. In a Stage 3 focus on innovation, high levels ofcompetence-base trust are required between business leaders and their



“executive-level IT leaders,” as well as between client and IT supplierteams.

▪ Motivational trust refers to the idea that both parties believe the rewardsand punishments they experience are geared towards achievement ofjoint goals, a Win/Win situation. Bonus structures and risk-sharing mech-anisms are elements that can be used to build this type of trust for therelationship. These are unlikely to have featured in the initial arrange-ments of a long-standing arrangement, but can be implemented subse-quently within a selective sourcing mindset. They are the Stage 3equivalent of the “fair return” approach of Stage 2.

We observed synergies arising across the trust model when innovationactivities were successfully completed, a simultaneous reinforcement of all threeforms of trust. Client C had achieved this rosy environment after a number ofyears of mutually beneficial projects with its supplier. Conversely, Case 2demonstrated a situation in which a series of failures created a “death spiral”environment in which all three forms of trust were degraded and neither partyhad sufficient trust in the other to move forward. The lack of technology invest-ment around the year 2000 at Client B created problems implementing innova-tive technologies and these failures harmed competence and personal trust. Thelack of trust also made modifying the motivational trust framework difficult andlittle progress was made in the relationship until the Supplier Y managementteam was replaced. The new team used small efforts to create personal trust andbuild a foundation for future growth.

High Levels of Measurement Specificity

Measurement specificity refers to the level of detail at which activity ismonitored, as prescribed in the outsourcing contract and any supplementaryarrangements. Measurement is a critical success factor in the relationships westudied, with one senior executive for Client B capturing the sentiment in hercomments:

“When people are prepared to put a lot more effort into specifying what theywant, I think they get a much better product.”

Conventional wisdom suggests that a relationship with high levels of trustdoes not require high levels of measurement specificity. After all, if the two par-ties truly trust each other, there is no need to detail every contingency in a con-tract. While the level of contract detail did differ among relationships in ourresearch, the stronger relationships maintained a tight reign over service levelsand costs (as in Case 3). These measurement mechanisms achieved two positiveoutcomes. First, the detailed attention to service levels gave the firms a clear ideawhere to target innovation efforts; and second, the firms were able to monitorcosts and benefits of innovation activities more effectively. The “trust but verify”approach demonstrates to both parties that the trust in each other was wellplaced, with a correlation between investment in measurement specificity andachievement of higher levels of innovation.



Effective Innovation Governance

Innovation within outsourcing relationships brings its own specific gover-nance challenges at three levels: what ideas should be selected for investment;what processes should be used to manage implementation; and how should eachparty be rewarded for success. In our research, we were surprised to find that—despite a formal recognition of an innovation objective—these issues were some-times addressed in an ad-hoc fashion, with each innovation opportunity beingaddressed individually. By contrast, effective innovation governance arrange-ments build confidence within the relationship that innovation efforts will behandled in a consistent and transparent way.

Within these parameters, effective arrangements could take different spe-cific forms, one requirement being that they were aligned with related processesof the client firm, or a particular business unit within it. The most convincingarrangements had the following features:

▪ An innovation board jointly populated by client and supplier executives.The board met quarterly to review and select new initiatives from theideas put forward from either side of the relationship and met monthly toreview the progress of initiatives already sanctioned.

▪ When selecting new initiatives, the board considered the economic argu-ments provided by champions of new ideas and the financial capacity forpursuing them within an agreed annual budget for innovation. However,it also considered whether it had the management capacity available forimplementation. Every selected idea required an allocated project man-ager as well as a champion, to ensure that implementation was subject toformal project disciplines. The board “owned” the available pool of projectmanagers, whose numbers were limited by consideration of how muchchange could be handled in parallel, as well as by the total budget avail-able.

▪ Since the champions of innovative ideas are inevitably reluctant to giveup on them, progress reviews gave particular weight to the views of themore dispassionate project manager when deciding to continue withimplementation of innovation initiatives.

▪ It was recognized that ideas of “benefit sharing” were difficult to imple-ment in these relationships since the target outcome for the client mightbe hard to evaluate in quantitative rather than qualitative terms. In themost productive of the partnerships we studied, the supplier’s incentive toparticipate was that it could achieve, through the innovation budget,additional revenues of several million dollars.

Whatever specific form they took, effective innovation governancearrangements were critical to the establishment of “motivational” trust withinthe relationship.



A Composite Model of Innovation in IT Outsourcing Relationships

Reflecting the pyramid shape of Figure 1, our research encountered manyexamples of IT operational innovations; a growing aspiration for achievement ofbusiness process-level innovations, with several convincing examples of success;and relatively few examples of strategic-level innovations. A holistic view of theresearch suggests the composite model of innovation enablers displayed in Fig-ure 3, where pursuit of innovation within IT outsourcing relationships followsan evolutionary learning model.

The model positions just two of the enablers as necessary to the achieve-ment of IT operational innovations. First the client must have in place the techni-cal knowledge that allows rich discussion of ideas at this level to be confidentlypursued with the supplier. Secondly, there must be personal trust across therelationship. In our least successful case study (Case 2), a lack of personal trustcompromised the ability to accomplish even the most modest innovation effortsat the IT operational level.

Success at the business process level of innovation requires that severaladditional building blocks are in place: the availability of business process designskills within the supplier, together with establishment of competence-based trust



FIGURE 3. The Enablers of Innovation for Outsourcing Relationships

All Three Types of Trust

StrategicExecutive Level IT Leadership

Selective Sourcing MindsetEffective Innovation Governance

Business ProcessClient-Industry Scope of Supplier

Client IT and Corporate Structure MatchSupplier Business Process Design Knowledge

IT Operational

Client TeamTechnology Knowledge Personal Trust

Tru

st

Mea

sure

men

t S

peci

fici

ty

and access to substantive depth of knowledge of the client’s industry; alignmentwithin the client of IT and business organization; and a selective sourcing mind-set, accompanied by effective innovation governance. The development ofprocess data management for Client A provides a good example. The supplier(Supplier X) had established a good track record of supporting the relevantprocess at one of its other clients within the defense industry. At the instigationof the UK business head, they agreed to transfer the relevant skills and knowl-edge. The business head and his supporting IT function were able to devisesourcing arrangements and innovation governance that were appropriate to thisspecific requirement. Over a six-month period, the business process was success-fully re-engineered and supported by new IT systems.

The biggest threat to success was the lack of executive-level IT leadershipat either corporate or business unit levels of the client. Fortunately, the client’sbusiness unit head had significant personal experience in IT and he was bothable and motivated to provide the necessary leadership. By contrast, in ourexample of a strategic innovation, executive-level IT leadership was well estab-lished at both the corporate level in Client C and in its submarine subsidiary. Asthe build-out for a long-running contract for submarines neared completion,Client C’s strategic direction was to move into marine overhaul—a market inwhich they had no recent presence. One project manager explained:

“The last time we did overhaul I don’t think there were computers. So how do wemake our systems work for this type of business? How do we quickly move our ITinfrastructure to these new sites?”

The CIO for the submarine division at Client C took the initiative toinvolve Supplier X in early and high-level discussions about the implications ofthe new direction. Elsewhere within the firm, Supplier X had the relevantexpertise, and during a long-established relationship Supplier X had developedthe motivational trust with Client C that gave them the confidence to respond.The joint project expanded the Client C environment into new locations, newmarkets, and a new product. Client C’s successful transition into the overhaulmarket was highlighted in Client C’s 2006 annual report.

Revisiting the Learning Curve with Innovation in Mind

It is the enablers, not a broader learning journey, that drives innovationperformance. Some of the enablers identified (e.g., client technology skills andmeasurement specificity) are highly relevant to the achievement of quality aswell as innovation outcomes. Other enablers are more specific to innovation,and putting them in place may present some challenge to the arrangementsestablished in pursuit of cost and/or quality objectives. Importantly, the learningcurve is a descriptive rather than prescriptive model. Case 4 provides an exampleof a company with hitherto in-sourced IT essentially bypassing two stages and“jumping in” to achieve innovation objectives. If innovation is the objective, theenablers point to the agenda for action—but reference to positioning on the



learning curve may provide additional insight into the challenge of putting theenablers in place.

Some Conclusions for Innovation within IT Outsourcing Relationships

Until recently, few, if any, major IT outsourcing decisions were triggeredby a desire to use IT as an enabler of innovation. However, many organizationshave now been outsourcing most of their IT activity for a decade or more, andthey are now making innovation a key future requirement for their relation-ships. While innovation can indeed be achieved within outsourcing, it is depen-dent on certain attributes within client and supplier, and in the relationshipbetween them. On the client side, the attributes identified would be neededwithin a value-adding IT function that was not outsourced: excellent technicalknowledge, alignment with the business, executive-level leadership, and anapproach that recognizes IT as a portfolio of activities with distinctive manage-ment needs. The supplier must be prepared to invest in business process designskills beyond its IT core, and the supplier can bring added innovation potential ifit has in-depth involvement in the industry sector(s) of its client. Apart fromdeveloping the style of governance that would be required to support innovationin any context, the key new requirement of the client/supplier relationship isthat it should develop the levels of trust that are more easily achieved within asingle organization.

APPENDIXAbout the Research

The concepts presented here are the result of a two-year study of theeffects of IT outsourcing relationships on business innovation. The researchincluded four primary case studies, featuring three “client” firms inaerospace/defense and one in the pharmaceutical industry. All were interna-tional firms with multi-billion dollar revenues and perceived to be leaders intheir sectors. Their IT outsourcing relationships, mostly of long standing, werewith three of the most prominent providers of such services. More than 70detailed interviews were conducted with client and supplier representatives inroughly equal measure. Interviews included client CIOs at the corporate and thebusiness unit levels, and the most senior account executives within the suppli-ers. Interviewees were asked to share their perceptions of all important aspectsof the outsourcing context and relationship and to describe examples of bothsuccessful and unsuccessful innovation initiatives, with their own insights intowhat had an impact on these outcomes. After transcription and analysis, ourfindings were presented back to research participants for discussion andvalidation.



Notes

1. P.F. Drucker, “The Discipline of Innovation,” Harvard Business Review, 76/6(November/December 1998): 149-157; A.H. Van de Ven, D.E. Polley, R. Garud, and S.Venkataraman, The Innovation Journey (New York, NY: Oxford University Press, 1999); H.W.Chesbrough and D.J. Teece, “Organizing for Innovation,” Harvard Business Review, 80/8(August 2002): 27-135.

2. M.J. Earl and D.F. Feeny, “Is Your CIO Adding Value,” Sloan Management Review, 35/3(Spring 1994): 11-20; K. Yamada, “The Innovation Imperative,” CIO Insight, (October 2001),pp. 35-42; M. Polansky, T. Inuganti, and S. Wiggins, “The 21st Century CIO,” Business Strat-egy Review, 15/2 (Summer 2004): 29-33.

3. Y. Shi, “Today’s Solution and Tomorrow’s Problem: The Business Process Outsourcing RiskManagement Puzzle,” California Management Review, 49/3 (Spring 2007): 27-44.

4. M.C. Lacity and R. Hirschheim, “The Information Systems Outsourcing Bandwagon,” SloanManagement Review, 35/1 (Fall 1993): 73-86.

5. H. Chesbrough, Open Innovation (Boston, MA: Harvard Business School Press, 2003); C.M.Christensen and M.E. Raynor, The Innovator’s Solution (Boston, MA: Harvard Business SchoolPress, 2003); D.J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabilities and Strategic Man-agement,” Strategic Management Journal, 18/7 (August 1997): 509-533; Ven, Polley, Garud,and Venkataraman, op. cit.

6. J.W. Rottman and M.C. Lacity, “Proven Practices for Effectively Offshoring IT Work,” MITSloan Management Review, 47/3 (Spring 2006): 56-63.

7. C.K. Prahalad and G. Hamel, “The Core Competence of the Corporation,” Harvard BusinessReview, 68/3 (May/June 1990): 79-91.

8. Lacity and Hirschheim, op. cit.9. T. Kern, L.P. Willcocks, and E. van Heck, “The Winner’s Curse in IT Outsourcing: Strategies

for Avoiding Relational Trauma,” California Management Review, 44/2 (Winter 2002): 47-69.10. T. Kern, “Relationships in Information Technology Outsourcing: An Exploratory Research

Study of a Conceptual Framework,” D.Phil. diss., Christ Church College, University ofOxford, 1999; I.R. Macneill, The New Social Contract: An Inquiry into Modern Contractual Rela-tions (New Haven, CT: Yale University Press, 1980).

11. W.M. Cohen and D.A. Levinthal, “Absorptive Capacity: A New Perspective on Learning andInnovation,” Administrative Science Quarterly, 35/1 (March 1990): 128-152.

12. J. Cross, “IT Outsourcing: British Petroleum’s Competitive Approach,” Harvard BusinessReview, 73/3 (May/June 1995): 94-102; J. Cross, M.J. Earl, and J.L. Sampler, “Transforma-tion of the IT Function at British Petroleum,” MIS Quarterly, 21/4 (December 1997): 401-423; M.C. Lacity, L.P. Willcocks, and D.F. Feeny, “The Value of Selective IT Sourcing,” SloanManagement Review, 37/3 (Spring 1996): 13-25.

13. F. Rockart, M.J. Earl, and J.W. Ross, “Eight Imperatives for the New IT Organization,” SloanManagement Review, 38/1 (Fall 1996): 43-54.

14. Earl and Feeny, op. cit.; D.F. Feeny, B.R. Edwards, and K.M. Simpson, “Understanding theCEO/CIO Relationship,” MIS Quarterly, 16/4 (December 1992): 435-448.

15. D.H. McKnight, L.L. Cummings, and N.L. Chervany, “Initial Trust Formation in New Organi-zational Relationships,” Academy of Management Review, 23/3 (July 1998): 473-490.

16. J.D. Lewis and A. Weigert, “Trust as a Social Reality,” Social Forces, 63/4 (June 1985): 967-985; M. Sako, Prices, Quality and Trust: Inter-firm Relationships in Britain and Japan (Cambridge:Cambridge University Press, 1992); O.E. Williamson, “Calculativeness, Trust, and EconomicOrganization,” Journal of Law & Economics, 36/1, part 2 (April 1993): 453-486; A. Zaheer andN. Venkatraman, “Relational Governance as an Interorganizational Strategy: An EmpiricalTest of the Role of Trust in Economic Exchange,” Strategic Management Journal, 16/5 (June1995): 373-392; L.G. Zucker, “Production of Trust: Institutional Sources of Economic Struc-ture, 1840-1920,” in B.M. Staw and L.L. Cummings, eds., Research in Organizational Behavior,Volume 8 (Greenwich, CT: JAI Press, 1986): 53-111.

17. McKnight, Cummings, and Chervany, op. cit.



from cost management to innovation and business value

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