Gain-sharing measurement in an information technology outsourcing relationship
Carlos Alberto Pereira
Brasil, Universidade de São Paulo
Faculdade de Economia, Administração e Contabilidade
Av. Prof. Luciano Gualberto, 908 – Cidade Universitária
CEP 05508-900 – São Paulo – SP – Brasil
Telefone: (55011) 3091-5820
Fax: (55011) 3813-0120
Brasil, Universidade de São Paulo
Faculdade de Economia, Administração e Contabilidade
Av. Prof. Luciano Gualberto, 908 – Cidade Universitária
CEP 05508-900 – São Paulo – SP – Brasil
Telefone: (55011) 3091-5820
Fax: (55011) 3813-0120
Palabras Clave: gain-sharing, information technology, outsourcing, pricing
Recursos Audiovisuales: proyetor y computador con MS Powerpoint 2000 o superior
Gain-sharing measurement in an information technology outsourcing relationship
Keywords: gain-sharing, information technology, outsourcing, pricing
This study presents a measurement model of gain-sharing in an information technology outsourcing relationship. The applied methodology is a case study in which the problem of gain-sharing measurement emerges in the relationship between two large-scale international companies that operate in Brazil. The main contributions of the study are: (i) a description of the characteristics and behaviour of costs in information technology; (ii) the establishment of the gain-sharing concept; and (iii) the proposing of a model for the measurement of gain-sharing in outsourcing activities. The findings of the empirical study show that information technology companies are highly structured with fixed costs and that cost-efficiency in services rendered for third parties should be measured through budget parameters.
The present study is concerned with the relationship between business providers and business customers of information technology services, and focuses principally on the measurement of cost savings in outsourced activities. The study approaches the problem of the measurement of gain-sharing as a component of remuneration policies for contracted services among companies. The methodology applied is a case study in which the problem of gain-sharing emerges in the relationship between two large-scale international companies that operate in Brazil.
The first part of the study considers the general concepts of outsourcing—focusing on the phenomenon of internationalization, methods of outsourcing, a literature review of outsourcing relationships, and considerations of pricing in outsourcing decisions.
The second part of paper presents reflections on, and the findings of, an empirical case study. After consideration of the competitive atmosphere that characterizes the credit card market in Brazil, this part of the paper presents operational aspects of the companies involved and the relationships between them in terms of services rendered and the operational flow of activities. The nature and behaviour of the costs involved in outsourced IT activities are studied. In this context, the gain-sharing measurement problem is identified. The main contribution of the study is the proposing of a model for the measurement of gain-sharing in outsourcing activities in information technology.
2.1 Internationalization process
Internationalization has become common among producer service firms that seek to grow rapidly in today’s highly competitive environment. Dicken (1992) has observed that there is no single explanation as to why such firms are expanding across national boundaries. As technological innovation accelerates and as new competitors rapidly emerge, businesses are finding their market position increasingly under pressure. To sustain growth and profit levels it is now often necessary to gain access either to new geographical markets (economies of scale) or to a new range of services (economies of scope).
According to Dunning (1989), the competitive advantages gained by multinational service enterprises can take may forms. These include: (i) economies of scale that allow prices to be lowered or service quality to be raised; (ii) the spreading of risk; (iii) economies of scope that allow wider collections of related services to be offered; (iv) greater proximity to potential customers; (v) increased local knowledge; and (vi) improved corporate identity.
Coe (1997) has noted that the computer services industry is now exhibiting strong trends in internationalization and diversification, This is one of the fastest-growing and strategically most important service sectors in advanced economies. According to Gentle and Howells (1994), the internationalization process in this industry has occurred as a result of the increasing globalization of both demand and supply in the industry. On the demand side, as key multinational customers have themselves internationalized, these customers have found dealing with different computer service companies in various countries to be unsatisfactory. As a result, major computer service companies have responded by providing comprehensive and consistent services in key cities located across a range of major industrial economies. On the supply side, Gentle and Howells (1994) have noted that competition in computer services is appearing from a number of new sources globally.
According to Auguste et al. (2000), quoting data from Dun & Bradstreet, third-party providers of routine operational services—such as the processing of payrolls, the movement of inventory and goods, the management of data centers, and the provision of extra manufacturing capacity—took in more than US$1 trillion around the world in 2000. Terdiman (1993) has noted that, according to the Gartner Group, the IT worldwide outsourcing market is estimated to rise from US$21.3 billion in 1997 to US$59.6 billion by 2005, with an annual growth rate of 14%. According to Loh and Venkatraman (1992) IT outsourcing—which is defined as the process of turning over part or all an organization’s IT function to external service provider(s)—is done to acquire economic, technological, and strategic advantages. Accordingly, increasing attention has been paid to building a successful partnership between the customer and the provider of IT outsourcing services.
Anderson and Narus (1990, p. 42-58) have defined partnership as “the extent to which there is mutual recognition and understanding that success of each firm is in part dependent upon the other firm”. Mohr and Spekman (1994, p. 135-152) have defined it as “purposive strategic relationship between independent firms who share compatible goals, strive for mutual benefits, and acknowledge a high level of mutual interdependency”.
According to Lee (2001), IT outsourcing is one of the major issues facing organizations in today’s rapidly changing business environment. This author observes that, in the 1990s, many organizations experienced difficulties in forming and managing a successful outsourcing relationship with service providers as the nature of outsourcing evolved from a contract relationship between the service receiver and provider to a partnership relationship. To overcome this problem, several firms established intimate relationships with their service providers on a partnership basis—which can be defined as an inter-organizational relationship to achieve shared goals of the participants.
The results of Lee’s (2001) study indicate that partnership quality is an important variable for outsourcing success. The strong relationship between partnership quality and outsourcing success indicates that fostering a cooperative relationship based on trust, business understanding, the sharing of benefits and risks, conflict resolution, and mutual commitment is critical to maximize the strategic, economic, and technological benefits of outsourcing.
Jennings (1996) has observed that outsourcing decisions are often emotive in that they challenge traditional beliefs of how the organization operates. Outsourcing requires rejection of the ‘we can do it all’ mentality. It also requires confidence that loss of ownership will not result in a reduction in control of activities and the weakening of core abilities.
Humphreys et al. (2000) have proposed a model for ‘make or buy’ decisions. The first step of the decision model is defining the core activities of the business. It is important to define what is meant by a ‘core activity’. A core activity is central to the company’s successful servicing of the needs of potential customers in each market. The activity is perceived by the customers as adding value, and is therefore a major determinant of competitive advantage. According to these authors these core activities should be developed in-house. In contrast, the activities for which the company has neither a critical strategic need nor special capabilities should be outsourced.
Nellore and Soderquist (2000) have observed that outsourcing is the consequence of the adoption of a resource-based strategy in which firms concentrate on their set of core competencies through which they can provide distinctive value for the customers, while outsourcing the rest of their activities. These authors have noted that the model of Quinn and Hilmer (1994) suggests that activities with a high potential for competitive edge and a high degree of strategic vulnerability should be realized in-house. A careful assessment of a firm’s assets and resources must precede any outsourcing decision to ensure that outsourced activities are restricted to: (i) those in which the firm does not have any special capabilities; or (ii) those for which the firm does not have a strategic need.
The reviewed literature points out that collaborations have positive effects and negative effects. The benefits include:
The risks and negative aspects include:
The three basic forms of procurement contracts are: (i) cost-plus; (ii) fixed-price; and (iii) gain-sharing. Price structures influence not only the incentives for both parties but also their interaction costs and the provider’s future negotiating position. According to Auguste et al. (2000) the two most common pricing choices—cost-plus and gain-sharing—have destroyed value more often than they have created it. With cost-plus contracts, providers lack any incentive to reduce costs. Customers sometimes believe that such contracts will save them money by capping the provider’s margins. But cost-plus contracts also limit the incentive of the provider to squeeze costs, because such contracts guarantee the provider a profit margin that no longer depends on the efficiencies it can realize by innovating, by exercising its purchasing power, or by hiring more productive staff.
A gain-sharing contract better motivates the provider to innovate and to reduce operating costs. However, it also raises interaction costs. In gain-sharing contracts, the parties agree on the baseline cost of providing a service. If the cost turns out to have been underestimated, the provider receives the difference. If the actual costs are lower than the baseline, the difference is split between the two parties in an agreed ratio. This is the most expensive kind of contract to negotiate and monitor because the parties have to define and accept precise cost projections for every situation. If the savings are lower than expected, further negotiations, in which each party blames the other, are almost inevitable. The incentives to innovate are also limited. Customers of one leading facility-management firm scrapped or modified gain-sharing contracts that had yet to expire. This occurred because the infra-service provider, having reduced costs “too much”, was reaping too large a windfall. Both costs-plus and gain-sharing contracts extract a price from infra-service firms as well by revealing their costs and profits (thus betraying their future negotiating position).
Auguste et al. (2000) have suggested that fixed-price contracts are a better option. When prices are fixed, providers keep the rewards from process innovation. This kind of contract is also less costly to negotiate and does not require customers to be continually auditing their provider expenses (as they are required to do under costs-plus and gain-sharing contracts). On the other hand, these authors have observed that the pricing model to be applied must consider each specific situation and, although providers should try to negotiate fixed-price contracts for their services, they must recognize that in all likelihood they will have to adopt different pricing schemes for different services. The choice of pricing scheme will depend on the receptiveness of the customer and the underlying economics of the offering.
The present study approached the problem of the measurement of gain-sharing as one of the components of the remuneration policies for services adopted contractually among companies. The case study that follows focused on the relationship between two large international companies that operate in Brazil. For reasons of confidentiality, the companies are referred to as ‘services receiver’ (SR) and ‘services provider’ (SP). SR operates in the credit card market, and administers a wide network of affiliated establishments while centralizing all completed card transaction operations under its brand name in Brazil. To accomplish this, SR depends on the technological and operational support of SP, a company that renders IT services for large-scale companies and governments throughout the world. The services that SP provides for SR involve capturing, processing, and transmission of data, and the execution of call-center functions for the affiliated establishments.
The pricing policy in the outsourcing relationship between SP and SR is based on the cost-plus model, with the total cost of services rendered monthly by SP being charged to SR with additional fixed remuneration. The differential aspect of the relationship between these companies is the fact that, apart from the cost-plus remuneration, there is a special contractual agreement related to gain-sharing. The gain-sharing computed yearly must be shared between the companies equally.
The global process of change is having significant effects on the Brazilian economy. The principal characteristics of the Brazilian economy in recent years have been: (i) low economic growth; (ii) gradual opening of the economy; (iii) privatization; (iv) relative stability of prices; and (v) technological advances. These characteristics have been especially marked in the telecommunication and financial industries, which are passing through significant market and structural transformation. Under the supervision of the Central Bank of Brazil, the financial system is gradually implementing a new Brazilian system of payments—through which diverse financial institutions will be interlinked and will carry out transactions on-line in real time among themselves, the Treasury, and other large-scale companies.
The credit card market is globally dominated by a few large brand names—American Express, Credicard, Diners, MasterCard, and Visa. Usually, the rights of exploration of these brand names (also known as ‘flags’) belong to specific investor groups. These authorize the use of the brand names in various countries, utilizing contracts that involve stock participation in a new enterprise, and thus producing an attractive worldwide business.
The service receiver in this case study (SR) is the holder of the exclusive right of use in Brazil of one of the prominent ‘flags’ of credit cards. Its stock control belongs to a group of large financial institutions that also operate in the country, apart from the participation of the ‘flag’s’ own international brand. SR has a large number of affiliated establishments and users of this brand of credit card in the commercial service sector. Through the credit card, the user can make purchases in one payment, or parceled out in various payments, from an international network of affiliated establishments to the brand. The user can also use the card to pay for purchases directly by debit in the user’s deposit account of the financial institution with which the user maintains a relationship. The user can also make cash withdrawals in other countries. The ready acceptance of credit cards is drastically modifying the profile of transactions made in Brazilian retail trade, and has significantly increased the volume of transactions made by operators.
SR opted to outsource some its activities because of: (i) operational difficulties associated with the growth in transaction volume; (ii) a need to maintain a focus on its main business; and (iii) the need to develop new competencies (for example, in information technology). SR relies on the support of SP to accomplish activities that require a high level of information technology—especially those that, although they are not core to SR’s business, are essential to its success in this changing environment.
The service provider in this case study (SP) is a large company with branches in several countries. The company is a provider of information-technology services, and administers complex data and voice communication networks. SP has absorbed all of the IT activities related to SR’s transactions in Brazil—including the capture, processing, and transmission of all data. These activities involve direct communication with: (i) affiliated establishments (merchants) to the brand name in Brazil; (ii) the receiver banks (where the merchants maintain their checking accounts); and (iii) the national and international issuing banks. Figure 1 represents the arrangement.
igure 1 Operational flow of the credit card business
The transaction data are captured by SP by electronic or manual means. Approximately 95% of transactions are electronic. The data are captured by the affiliated establishments and immediately sent to an exchange headquarters at which a decision is made on whether the transaction should be authorized. If authorized, the data of the transaction are stored, processed, and transmitted by SP to the receiver bank (where the merchant maintains its deposit accounts) and to the issuing bank (where the card user maintains its accounts). Credits and collections are realized, and this results in an accomplished transaction.
In this process, speed, security and low cost are critical factors that determine the success of the business. The decision of SP to outsource these IT activities takes into account these factors of process, speed, security and low cost, as well as the need for SP to maintain focus on its main business by delegating activities that require highly specialized know-how.
The services rendered by SP for SR involve the following activities: (i) development and maintenance of systems; (ii) maintenance of database of the clients; (iii) capturing, processing, and transmission of transaction data; (iv) call center service; (v) operational support to the affiliated establishments; and (vi) back-office services.
The costs incurred in the outsourced activities are: (i) administrative; (ii) telecommunications; (iii) physical space; (iv) hardware; (v) software; (vi) maintenance; (vii) computer usage; (viii) outside labor; and (ix) support. The distribution of costs incurred in the accomplishment of the outsourced activities are shown in Table 1.
Table 1 shows that the principal elements of costs are support (43%), computer usage (27%), and outside labor (14%). Collectively, these respresent 84% of the total costs.
These costs are incurred at the level of administrative units. The administrative units are cost centers—which can be either operational or support. The operational cost centers (OCCs) execute production and costumer-service activities linked directly to the accomplishment of the transactions (manual or electronic). The support cost centers (SCCs) execute support activities to the OCCs—such as system development, planning, training, and other back-office activities. Taken together, the OCCs generate 66% of the total costs, whereas the SCCs generate 34%.
The cost centers are basically structured as fixed costs, with the most significant of these being support, computer usage, and outside labor. The major support costs are: (i) the salaries and wages of personnel; (ii) the costs of computer usage, expressed as computer processing units (CPUs); and (iii) the costs of outside labor. Of these, wages costs are essentially the same in OCCs and SCCs., computer costs are more significant in OCCs than in SCCs, but outside labor costs are greater in SCCs than in OCCs.
Some elements of fixed costs (such as wages) are valid for short periods of activity whereas other elements of fixed costs (such as costs of hardware and software) are valid for larger periods of activity. Typically, fixed costs refer to the use of resources that possess a limited capacity for production. Within a determined interval (range) of activity of any given cost center, the fixed costs remain constant (provided that production capacity is not surpassed). However, if the installed capacity were to be increased, a larger quantity of fixed resources would be required. As long as the new installed capacity is not surpassed, the amount of fixed costs will remain constant. OCCs, for example, have a planned structure of resources (equipment, software use licenses, people, physical space, and so on) to process a predetermined volume of transactions (with the time of computer use constituting the unit used to measure the work). Above this limit, investments in new resources become necessary, thus elevating the production capacity to a new higher level and expanding the range of activities.
In planning the necessary resources for a given cost center, the number of transactions and the use of computer time might be important, whereas, for another cost center, the number of employees or the size of the area to be attended might be more relevant.
In this case study, it is significant that the total costs were basically formed by fixed costs—that is, there was no direct proportional relationship between these costs and the volume of processed transactions. Figure 2 shows monthly transaction volume compared with the annual total costs and unitary costs.
igure 2 Transaction volume, total costs, and unitary costs
As previously noted, several studies consider different aspects of outsourcing relationships. However, no study has specifically addressed gain-sharing—apart from the work of Auguste et al. (2000), which touched on the subject.
The authors of the present study define gain-sharing as the sharing of a benefit obtained by developing an activity in a more economical manner in relation to an established parameter. As an element that seeks to express the benefits realized in the business relationship between two companies, it is presupposed that gain-sharing should:
The first premise is the most important because it drives the proposed methodology for measurement of gain-sharing. According to the definition provided above, gain-sharing is related to cost savings and to cost-accounting concepts of price and efficiency. According to Horngren at al. (2000), price variation reflects the difference between actual and budgeted input prices, whereas efficiency variation reflects the difference between actual and budgeted input quantities.
In this case study, the benefits obtained from the business relationship between the companies were increased by:
The gains produced by increasing activity volume generated an additional contribution margin to SR, proportional to the volume of business. The increment in the activity volume was promoted by SR, whereas SP supported the growth and made it possible by allocating resources (human, physical, and technological) and adjusting the capacities of the various activity centers. SP was responsible for being pro-active in implementing technological and operational solutions to meet the levels of activity reached by SR. Therefore, although SP did not increase activity volume, it did produce an intangible benefit by assisting in the processing of a larger volume of activity. This required more responsibility, larger operational risk, and less flexibility.
This benefit should not to be confused with gain-sharing, but it should be included (and remunerated) in the pricing agreement between the companies—in accordance with the premise that the return should have relationship with the investment made and the risks assumed. It would be unjust to maintain a fixed level of remuneration to SP for assisting in volumes of services significantly higher than those originally assumed. Although it clearly generates a benefit for SR, this matter should be treated in the pricing policy of the services, rather than through the concept of gain sharing.
In contrast, the gains that SP provides to SR through cost savings (when less resources are consumed than previously assumed) should be classified as gain sharing. This is because:
In view of the above discussion, the question arises as to how to measure gain-sharing in this kind of operational environment—that is, one characterized by a high volume of fixed costs and great oscillations of activity volumes. The answer to this question is presented through the proposition of a model of measurement of gain-sharing.
The fundamental premise of the model is the existence of a parameter that is present (and can be elaborated for different volume levels) in the flexible budgets and standards of each cost center. The model is comprised of four steps.
As previously noted, the amount of fixed cost stays constant within a determined interval of activity. The measuring of the savings of fixed costs is through a comparison of the forecast total value of expenses (for a given level of activity) with the actual total value of the expenses incurred. The following situations can occur.
In this case, the economy of fixed cost should be computed by comparing the total value of planned expenses (for the level of activity executed) with the total value of actual expenses. Cost efficiency exists at any point within the relevant interval because the actual costs are smaller than the costs planned for the interval.
In this case, the relevant interval in which the activity volume occurs should be determined, and this should fit with the corresponding budget of valid cost for the interval of relevance. In the same way, the cost efficiency is measured by the difference between the costs incurred and the costs estimated for that interval of relevance.
Table 2 shows the steps and procedures required for the implementation of the proposed model.
In the case study under consideration, the cost center of production is an organizational area responsible for the capturing, processing, and transmission of the relative data of the realized transactions of SP. Table 3 shows the planned performance (original and revised) and the realized performance of an administrative unit in a month.
In Table 3, it is observed that the total costs originally planned for the period were $1,018,737, for a level (range) of activity of 300,000–500,000 minutes of computer processing, and $1,788,782 for 500,001–700,000 minutes. The revised values were, respectively, $1,121,486 and $1,938,234 (staying in same activity intervals). The performance realized in the month (corresponding to 600,000 minutes of computer processing) was a total cost of $1,886,182.
Comparing the realized costs with the planned costs for the volume of 600,000 minutes, it is observed that there was a total gain of $52,052—which corresponds to the total of the cost variations in the period. Among the favourable variations, the most significant flowed from the use of computers ($41,826) and support ($11,987). In contrast, variations related to external services ($4,202) and to physical space ($662) were negative—demonstrating that the costs were larger than forecast.
Apart from measuring the total amount of variation, the model identifies the favourable and unfavourable variations in cost, thus contributing to the diagnosis and ongoing improvement of performance.
The outsourcing of IT activities is characterized by the establishment of a relationship in which both parties (buyer and provider) obtain competitive advantages by maintaining a focus on their respective businesses. In such a relationship, the question of measurement of gain-sharing arises. Gain-sharing refers to the sharing of a benefit obtained by developing an activity in a more economical way in relation to an established parameter. The gain-sharing concept is related to cost savings generated by providers of services in an outsourcing relationship.
The adoption of the proposed model, based on budget parameters, allows the measurement of gain-sharing and contributes to greater transparency in the relationship between the companies. The proposed model allows an analysis of the earnings in detail (by area, by activity, and by resource element), thus identifying opportunities for improvement. Implementation of this model can result in cost savings and provide measurable benefits for both parties to an outsourcing relationship.
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