Insourcing – Reversing the Trend?

August 31, 2005

Over the course of the past couple of years, there has been much made of seemingly inexorable flow of outsourcing projects, and in particular the outsourcing of various IT and business process functions to lower cost offshore locations. However, amidst all of this has been a more gradual but significant increase in the number of previously outsourced functions being brought back inhouse, the latest one to hit the press being the Prudential’s consideration of the insourcing of its data centre requirements, currently handled by Capgemini. What then are the drivers for insourcing, and what are the issues to be addressed by an organisation which is considering it?

Why insource?

The answer to this issue probably lies in a return to the analysis of why the relevant functions were outsourced in the first place. The major drivers behind a decision to outsource will usually include one or more of the following:

(a) a means of lowering costs, either by reason of the supplier’s economies of scale or access to better materials/tools, or because of the labour arbitrage associated with an ability to do work offshore;

(b) improving access to leading technologies/best practices;

(c) creating greater flexibility (eg in terms of being able to ramp up and ramp down numbers of required personnel) and accordingly improving speed to market;

(d) creating certainty over the level and means of service provision, and gaining control over sometimes disparate functions;

(e) rationalisation and integration.

Suppliers of outsource services will obviously claim to be able to provide their clients with the majority if not all of the above. However, in return they will usually ask for the client to commit to a relatively lengthy contract term (justified by the supplier’s need to recoup its investment in both bidding for the project and setting up the infrastructure required for the delivery of the services, and its willingness to provide lower rates only in return for guaranteed work over a longer period of time).

If all goes well, there is no reason why all, or at least a substantial proportion, of these perceived advantages cannot be obtained. It is certainly the case, for example, that a Tier 1 or Tier 2 supplier offers attractive career prospects for highly skilled personnel, and they may accordingly be best placed to assign well qualified and experienced staff to work on their clients’ projects. Likewise, their ability to utilise shared service and/or offshore facilities can dramatically drive down costs. With a much wider pool of personnel to choose from, they should also be able both to increase the numbers of people working on a particular client’s project (eg to deal with seasonal peaks or substantial change requests), and decrease them (eg by reassigning them to other outsource projects) without having to go through a costly redundancy exercise.

However, the unfortunate reality is that not every project lives up to expectations. Dissatisfaction with the results engendered from outsourcing seems to be running at a surprisingly high level, and Gartner has estimated that four in every five outsourcing agreements will need to be renegotiated at least once over the course of its term. Whilst there may be many reasons for such renegotiations (some of which may be “benign”), one suspects that the majority of such renegotiations relate to efforts to try to fix something which has gone “wrong” in some way, whether in relation to pricing, service levels, overall service delivery or whatever.

Many such problems and consequent renegotiations might be avoided by the parties incorporating appropriate provisions in their contracts, for example by incorporating benchmarking mechanisms so as to ensure that the prices and service levels can be adapted over time to reflect the prevailing norms in the relevant outsourcing sector. However, others are harder to predict or to deal with short of invoking contractual remedies such as rights of termination (especially if the root cause is simply a supplier which has over-reached itself, or which has mismanaged the project). In such circumstances, the client may find that outsourcing really does involve an inevitable loss of control in that, in extremis, the supplier will invariably fall back to what the contract provides that it either does or does not have to do, which may be extremely frustrating when compared to the flexibility which is inherent in managing one’s own staff.

Moreover, even when a supplier is performing in accordance with expectations, the actual financial advantages which it is able to offer may actually be more modest than might be assumed. In comparing the capabilities of internal IS departments as against those of outsource service providers, the Information Systems Research Center (ISRC) concluded that the economies of scale stated by vendors were largely oversold. In particular, they went on to note that:

“Internal IS Departments often possess equivalent or superior economies of scale to vendors for many IS functions. In general, we have concluded that vendors are inherently more efficient at providing technical expertise and serve to minimize a customer’s opportunity costs by providing commodity IS services while internal IS departments focus on more strategic IS issues. In general, internal IS departments are inherently more efficient at providing business expertise, minimizing transaction costs (cost to coordinate, monitor and manage an IS function), minimising shareholder costs (internal IS departments do not need to generate a profit) and minimising marketing costs (internal IS departments do not need to advertise or solicit customers). In addition, large IS departments have comparable economies of scale as vendors in the area of data processing costs, hardware purchasing costs, and software licensing costs.”

Further cost savings can be achieved by larger clients if they are able to establish their own offshore delivery centres, and therefore themselves take advantage of the labour arbitrage without having also to fund the supplier’s margin. Whilst setting up such an operation from scratch may be daunting, the “Build-Operate-Transfer” model (whereby an existing supplier sets up the service function, operates it for a while on an outsource basis and thereafter transfers it in full and for an agreed fee to the client) is a popular one, and enables the client to insource a tried and tested service delivery function.

Equally, greater degrees of workforce flexibility can be acheived other than via full outsourcing. Many customers now look to augment their permanent staff not with full time contractors, but with staff employed by IT service providers on a “bodyshop” basis, whose numbers can be increased or decreased on relatively short notice, and with minimal financial consequences.

Rationalisation and integration should similarly be attainable without the need to go through a fully fledged outsource; whilst it is true that an outsource might neatly sidestep difficult internal political issues and/or be a means to try to get someone else to sort out a known “mess” which has developed, it certainly seems to be an expensive and potentially cumbersome way of going about achieving change within the business.

Taking the above into account, one can begin to appreciate why outsourcing may begin to lose at least some of its apparent appeal, and why Deloitte estimated that nearly two thirds of the organisations they surveyed had insourced at least some forms of previously outsourced services (even if the initial process of outsourcing could be said to be a necessary “first step” to getting the relevant services organised and defined). This is not to say that outsourcing is in any way an idea whose time had come and is now “going” again; it is undoubtably the case that very significant benefits remain to be gained through outsourcing, and indeed we are probably only just beginning to see the prospects for cost and service improvement in the field of Business Process Outsourcing (BPO). However, what it does highlight is the need to very carefully compare the potential benefits of outsourcing to those which might be achieved by way of some internal re-engineering.

How to go about it?

Assuming that a service or business function has in the past been outsourced, it may not in fact be as easy as one might think to simply take it back inhouse. A number of factors will need to be considered.

First, there is the question of the existing outsource agreement. Unless it is coming to the end of its term so as to be terminating “naturally”, there will be the question of what kind of payments may be due to the supplier in relation to it relinquishing its rights to provide the services in question. Hopefully the agreement will have pre-empted this by incorporating a right of termination for convenience and a mechanism for then calculating the payments due to the supplier (eg in relation to its as yet unrecovered costs and expenses arising by virtue of the termination, etc), but otherwise this will need to be negotiated with the supplier. In any event, there will certainly need to be a measure of assistance from the supplier in transferring the affected services or functions back to the client, and it is unlikely that this will come for free.

Secondly, the client will need to consider what exactly it will need in order to re-take responsibility for the services or functions concerned. Aside from purely pragmatic issues such as office space and the like, there will usually be various assets (eg computer hardware) and third party contracts (eg software licences) used by the supplier in the course of the outsourced services; will these be transferring back to the client, and if so will there be a cost associated to this? If they are not to transfer, can the client source alternatives/replacements for them, and if so at what cost? Whilst the outsource agreement will again hopefully have pre-empted these issues (and ideally have imposed an obligation upon the supplier to transfer any assets which were wholly/substantially used in the provision of the services, and to ensure that any third party contracts were freely novatable to the client), one issue which is frequently overlooked is the supplier’s own proprietary materials and software. In a longer term deal, such supplier products may have become deeply embedded in the underlying systems or processes, such that there will be a continuing dependency upon them. It may accordingly be essential to obtain continuing licence rights to utilise them, at least on an interim basis until they can be replaced without impacting unduly on the continuing services. This should be less of an issue for the supplier than it would be if the services were being passed across to a replacement outsource service provider, in which event the supplier would have justifiable concerns regarding the protection of its confidential information and proprietary products.

Thirdly, there is the question of knowledge. When a business outsources a particular function, it traditionally loses not just the responsibility for the day-to-day provision of the underlying services, but also much of the bedrock of acquired know-how which has built up over years and which underpins the services. This is because such knowledge is primarily located in the heads of the staff who undertake such services, and who will usually either transfer to the supplier, be made redundant or have been transferred to other roles. Over time, such original client employees may move on to other roles within the supplier’s organisation, or may take on roles which are not exclusive to the client’s requirements, such that they may not automatically transfer back to the client by reason of the Transfer of Undertakings (Protection of Employment) Regulations 1981. The client must therefore take care to ensure that it will be having transferred back to it sufficient staff to ensure that the services can continue to be provided to the required standard (which is likely to be a particular difficulty when services have been transferred offshore, such that few if any of the supplier’s staff are likely to be transferring in turn to the client), and/or that it has alternative staff available to it who can either refresh their knowledge on the basis of their previous involvement with the functions concerned or get up to speed sufficiently quickly.


Just as outsourcing is not necessarily the solution for every organisation, so insourcing will not always be the appropriate way forward when an outsourcing initiative fails to deliver all of the envisaged benefits. However, whenever an outsourcing project is being proposed or is coming up for retender, the insource option is one which should be carefully considered, especially if cost/labour arbitrage is not the key driver and issues of day-to-day control are paramount importance.

Kit Burden is a Partner at DLA Piper Rudnick Gray Cary, an SCL Trustee and Chair of the Outsourcing Interest Group.