Outsourcing IT is nothing new. But in recent years it has changed shape several times to reflect new, and arguably better-planned, organizational objectives. And best practices for creating contracts are now evolving that promise to move outsourcing from a road often pockmarked with potholes and lawsuit-bound to a more reliable relationship for both provider and customer.

And although the practice is still leading-edge, contracting for outsourcing joins other service spends in the portfolios of procurement departments. "It's part of a logical evolution," says Bob Talbott, vice president, supply management for Fireman's Fund Insurance in Novato, Calif. "To get out of the typical churning-and-burning purchasing transaction mode, as a discipline we had to [prove] that we have other skills—business analysis, financial analysis, process reengineering, the ability to facilitate cross-functional teams, the ability to make sure the supplier base aligns with company strategy—[because] those skills, which a lot of procurement groups honed through service contracts, are directly transferable to IT outsourcing contracts."

Worldwide, outsourcing was a $293.4 billion industry last year, according to a study by Gartner. The Stamford, Conn. market research company estimates outsourcing will grow to $429.2 billion by 2008, a 7.9% compounded annual growth rate. Although that's way down from the late 1990s, when growth was pushing 20%, it's high enough to make it one of the brighter spots in the entire IT industry, according to Robert Brown, principal analyst for Gartner and one of the authors of the study.

Outsourcing watchers divide the market into two segments, information technology outsourcing (ITO) and business process outsourcing (BPO). ITO consists of outsourced IT activities, usually ongoing, longer-term ones, as opposed to project work like software development and new system implementation. BPO includes outsourced business functions and usually carries with it associated IT activities—customer relationship management (CRM) systems with customer service functions, for example.

Both ITO and BPO have been around for decades Although BPO is growing faster, ITO is still the larger of the two segments.

ITO is, by most accounts, the more mature, but companies have routinely outsourced their payrolls for almost half a century. What's new in both segments is a growing variety of services and greater demand for those services from outsourcing customers. ITO has grown to include anything from the help desk to complete IT departments, and BPO now includes entire customer service departments, HR (Human Resources) operations and even procurement. Offshore BPO, especially when it's a customer-facing process like customer service, has become a political hot button.

"The first wave of outsourcing was strictly IT," says Brown. "We started to see IT outsourcing gain traction in the 1980s and into the early 1990s as very big-ticket, holistic swapouts of IT departments, where the entire department was thrown over the fence to the service providers."

By the second half of the 1990s, Brown continues, more specialization began creeping into ITO. Outsourcers began focusing on desktop management, networks, help desk services, security, server hosting and so on. Today, "you've got two tracks of IT outsourcing. On one hand, you still have companies pursuing big, strategic megadeals. On the other, you have more selective outtasking." The latest ITO trend is toward what Gartner calls utility services-outsourcing, but on a pay-as-you-go basis. Though a hot topic among analysts and service providers, utility services are still immature and many potential customers are hanging back.

The history of BPO is almost the inverse of ITOs. "If you started off in IT outsourcing with big, holistic deals, in BPO you often started out with very selective deals," he says. "Payroll outsourcing, for example, has been happening for years, though companies may not even have thought of that as business process outsourcing. By the late 1990s, there were companies that elected to do very holistic outsourcing of entire processes. HR and finance and accounting have been the typical areas where we've seen those big, strategic deals."

More recently, Brown adds, companies have begun outsourcing select subprocesses—benefits administration and payroll, for example—instead of the whole HR function. More specialized BPO services are also evolving to meet the needs of specific industries: check clearing services and credit card processing for financial institutions, for example.

"The entry point for business process outsourcing is an entirely different buying center than for IT outsourcing," Brown says. "IT outsourcing is still very much the domain of the CIO (Chief Information Officer), where BPO is absolutely a CFO-led (Chief Financial Officer), and in some cases a CEO-led (Chief Executive Officer), undertaking, depending on the magnitude of the contract in question. There's a lot of input from business unit managers. Worst case, the CIO is the last to know."

Outsourcing remains popular because when it works, it saves money. "Companies today are being driven to deliver more services, more functionality and more value for less money," says James Champy, business author and chairman of Perot Systems' consulting practice in Boston. "It's all part of a broad and pretty dramatic improvement in productivity that's going on in multiple industries." Outsourcing is usually just a way to keep costs in check.

A few years ago, Champy recalls, a lot of outsourcing was driven by companies' need to find IT competency they were lacking. The outsourcing providers delivered expertise as well as savings. And before that, companies went to providers to cash in their IT investments and improve their balance sheets. "The deals that were around 10 years ago were deals that had companies selling their IT operations to outsourcers, and some of that still goes on. When they did that, they took an asset that showed little or no value on their balance sheets, sold it for $100 million, and suddenly you had more on the assets side of your balance sheet."

But savings today is more likely to involve concentrating assets and effort on core competencies, and outsourcing noncore activities to specialists. "Take payroll outsourcing, classic BPO," says Bob Rosetta, chief sourcing officer for JP Morgan Chase in New York. "Is payroll a core competency of my business? No. Are there people out there to whom it is core? Yes." Outsourcers have the tools and the expertise to do the job better and cheaper, he notes.

"You have to ask, 'How consistent is the outsourced service with the primary purpose of your corporation?'" adds Sean Chou, chief technology officer of Fieldglass, a Chicago company that makes a software product called InSite that helps users create and monitor outsourcing contracts. "If it's something you feel has nothing to do with your strategic direction and has nothing to do with your primary product, then it's an area you don't really want to build up expertise in." Nor is it usually an area where it makes sense to invest heavily in equipment and staff. "You tend to build out all this stuff to handle peak capacity, when in fact, 80% of the time you're nowhere near that peak capacity."

Historically, outsourcing has been prone to failure. "A lot of these deals are golf course deals," says Dave Whitinger, director of consulting for International Computer Negotiations, a consulting firm that helps organizations work out successful deals with outsourcers. Whitinger is also program director for Caucus, an organization that aims to improve procurement of outsourcing services. "The suppliers are smart enough to dial in a deal with the senior executives, and then it kind of comes down from the mountain. There is no disciplined process. Those are the kind of contracts that are really one sided and they're the ones that wind up in court."

Another reason deals go bad is that business conditions change and contracts with outsourcers aren't flexible enough to take that into account, according to Whitinger. "If you went out and did an honest survey of clients who have outsourced work and technology, you would find a surprising amount of discontent. A lot of that comes from the fact that the service providers are doing a superb job of running the operations, but they're not able to respond to business changes that clients often have because the deals are rigidly structured. There's very little room to add the value that the client ultimately wants."

Rosetta agrees: "If you look at some deals that are multiyear—say five, seven, 10 years—they're very difficult deals to craft. You need a contract that's extremely flexible to change with business conditions." A lot of outsourcing deals fail because they're put together poorly in the first place, he continues. "If the client didn't really understand what he wanted, then clearly he's going to have a disconnect with his supplier. The more mature your sourcing process, the better your odds of doing a good deal that's going to last."

"One of the biggest pitfalls is that you get what you contracted for, but it's not what you need," says Talbott. "That happens because of a lack of clear business strategy. If the sourcing department isn't in lockstep with the overall company strategy, then you could end up with a wonderful contract, but it's not what the business needs." A similar danger, he continues, is lack of confidence in where your business is headed. "A lot of these deals are done with projections on demand or the business environment, and the outsource provider makes its investments based on that. You've got to be very careful because that's a relationship destroyer if you aren't open, honest, and do the due diligence to make sure you know what you're talking about."

Another potential problem, Talbott suggests, is control. "It's important to set a level that you feel comfortable with. Too much, and you end up micromanaging your outsourcer. The outsourcer becomes a group of contract employees, rather than a true outsource provider, and much of its value disappears. Too little control could put you in a situation where you don't know what's happening with a key business process."

Perhaps because outsourcing contracts have had their share of problems, more of them are coming under the purview of procurement departments. Whitinger reckons procurement is involved in about half of all companies, though the extent of that involvement varies greatly. "In some organizations, it's just approving the purchasing order. But in the organizations that follow best practice, there's a dedicated purchasing team with folks that understand how to do technology deals."

Rosetta sees a divide between larger and smaller firms. "I think the groups that are more mature and have a large level of spend have sourcing or procurement organizations. Their operating models are varied, but in the larger organizations, there probably is some formal sourcing process that they use to get these deals done." In fact, he says, outsourcing deals aren't a whole lot different than any other service buy, though an extra measure of diligence is often necessary when contracting for ITO and BPO because many providers are new to the business.

Purchasing must be involved in setting up ITO and BPO deals, says Chou. "They have to shepherd the process the way they always have in terms of just selecting the provider. They are definitely going to be the experts when it comes to conducting a fair and impartial evaluation of suppliers. They're unquestionably going to have better expertise in that area than anyone else in the organization.

"Purchasing as an organizational construct has really emerged in the last few years. Its power and effectiveness has been growing steadily, and it's shown how effective having a purchasing organization can be—first with goods and then with contract labor and now with more and more services. I see purchasing organizations growing in power and influence as they complete one successful project after another. They've been able to prove that they are generating returns on investment because they're dealing with hard dollars."