Software Outsourcing and the hidden costs
The software outsourcing industry has matured to an acceptable level during the last decades – actually to an extent that some Clients jump into the ecosystem blindfolded without sufficient knowledge about the pitfalls – “hidden” costs.
In this article, you will be made aware of some of the most known hidden costs, some that you are only aware of if you have been in the business for decades, some myth busters and finally the “killers” that will ruin you if you don’t stay clear.
This article is created as a reminder to software outsourcing Clients, Providers, Advisers as well as Cultural coaches that “hidden costs” are not to be taken lightly. The list of “hidden costs” are far from complete, but at present stage sufficient as a guideline – not only to directly save costs but also as a list of risks that need to be addressed in almost any planning of a long-term outsourcing partnership. The article contains so much information that it will be overwhelming to some readers to grasp it all in one read, but my hope is that the readers will use it as a reference. for the same reason, the article is “live” and will be updated with references and links to data.
If you read the article to the end you will also realize that the preparation phase including selection of the best matching partner are much more important than can be written in articles, books, and papers about the subject – and the very reason why copycat and lightweight setups are much less likely to succeed compared to stealth strategies concluded by a holistic matchmaking phase encompassing the priority and weight on an individual company basis.
What is ‘hidden costs’?
‘Hidden costs’ is, in general, a term for the costs that a Client don’t see in the marketing material presented by a Service Provider. It is not that the service providers try to hide anything but simply because some issues are general issues that are expected to be known by the Client before entering the ecosystem, or on a macro level depending on global factors or factors related to the Client organization or Client origin. The level of “hidden costs” is by far most affected by the level of maturity in the Client organization.
Some of the most known “hidden costs”
For many Clients outsourcing of IT services turn out to be the second most change factor since the foundation of the company. Careful analysis of needs, making a long-term strategy and a proper pre-selection of potential partners are too many clients surprise the biggest success factors.
The idea of outsourcing doesn’t come from one day to another. To get things done Clients have usually tried many onshore options from local hiring to the use of external consultants. At some point, it can seem like going from fixing one problem to the next without a long-term solution. The expenses occurred can even seem so devastating, and so many opportunities lost, that any alternative is for the better.
That is maybe the first mistake a Client can make. Outsourcing is NOT for everyone!
Outsourcing or offshoring is for many clients the first step in an unknown land. Not only can the many external factors be unknown, but even more surprisingly the “due diligence” of own organization can turn out to be an even bigger task. Not only can it turn out to be difficult to outsource existing or new product there can also be resistance to change by employees as well as management. Even the organization can turn out not to fit collaboration with an external organization. It all depends on a lot of circumstances and factors. Just thinking that if the competition can do it so can we are a dangerous approach. For the same reason, there are no shortcuts like copy/paste or even recommendation of an external partner thinking they can do the same job in your organization as in another could turn out to be plain wrong.
A deep analysis of the complexity is mandatory if a solid strategy is a wanted outcome.
A top-down decision about outsourcing without iterations, analysis, the involvement of past and future key stakeholders will historically be a very shortsighted strategy and in worst case turn into a disaster. Some leaders don’t realize that a top-down decision will not drip down the organization and fix all obstacles by the operational part of the organization. C-level involvement is needed all the way. A well-planed strategy where most of the factors for success/failure addressed is mandatory. It is far from uncommon that the analysis and strategy phase takes 6-12 months to finalize.
Pre-selection of Vendors
The next hurdle facing a software outsourcing Client is finding the perfect partner. I have deliberately used the word ‘perfect’ in order to emphasize that anything less is a big compromise. A client should be able to describe preferences for a potential partner upfront based on analysis and strategy. If a client will use external help in this phase deeply depend on maturity, procurement experience from the outsourcing sector and willingness to use internal resources scanning the marked. Just a few years ago it was only fortune-500 companies that could afford external advisory, and even they were only focused on the top-100 outsourcing providers. Today the mid-marked of outsourcing providers has grown, not only in number but also by specializing in technologies and verticals that the Giants can’t compete with. The flip-side for Client organizations ranging from start-ups to fortune-500 is that the perfect partner is now one out of 20.000 ISVs. If leaders want to make data-driven decisions it is within reach by offerings from specialized advisory houses that can provide vetted data on a majority of the players in the marked (i.e. 1.000 vendors), and some to a fraction of the costs and an internal team would use on analyzing 50 randomly chosen ISVs. A decade ago Advisers were challenged with low maturity on both sides of the table whereas today the major efforts need to be done on the Client side in the preparation phase. Due to these factor changes, a Client could face advisory expenses reaching 0.2 – 2% of the total budget every year. Today the pre-selection, Provider maturity and transparency in the ecosystem are key factors that enable advisors to deliver a much higher degree of service quality reducing the pre-selection expenses to a one-off expense as all parties know the benefits of long-term engagements.
The parameters used to find a partner is different depending on the outsourcing model and 100 other parameters, and even if an external partner has helped pre-selecting 2-5 potential partners, it is advisable to make the final selection based on a tender process and preferably by having visited the candidates. The pre-selection handles the RFI part of a tender process, but an RFP process is needed to clarify the needs. The tender process should preferably be concluded with one or more on-site visits in order to include the human factor of mutual chemistry. This can be done as a due diligence and finally for the final selection and contract signing.
Oftentimes Clients realize during the analysis and strategy phase that small or big organization changes are needed in order to accommodate collaboration with an external partner. It can be anything like hiring managers and developers with a global mindset to complete re-organisation. It all depends.
What once was a dream team of managers and employees can turn out to be the biggest obstacle to successful management and collaboration with remote employees.Leader style, management on distance, interfacing to another culture are all factors that need to be addressed in an early phase. Solutions need to be found that ensure present employees get an opportunity to be part of the journey and at the same time ensure that not one single employee or manager become a showstopper. Extrovert employees tend to have a better chance of getting success in the interfacing role and some introvert developers sometimes need to be screened for external activities in order to continue excelling in what they do best – and is still needed internally in the Client organization. Never forget that people are the key to success and that it is human to fight changes. Finding the right balance between nudging and top-down management is almost an art and can turn out to be a “hidden cost”.
Language barriers can be huge. Maybe it turns out that all of the Clients codebase or documentation is in a native language, incompatible with an international environment. For native English speaking persons, it often turns out to be a huge barrier to communicate and understand people with another dialect, whereas non-native speaking people seem to have a more easy task to adjust. As communication is a key factor to success, language skills, internally in the Client organization as well as at the provider, should be considered carefully during the analysis phase and during preselection of a Vendor. A hidden cost can easily occur, especially if it turns out that the staff on one or both sides of the table needs education in order to reach the needed communication level.
Some people pinpoint cultural differences as one of the key factors to “hidden costs”. Having lived 7 years abroad and managed a variety of nationalities and interfacing with many cultures, I personally have reached a level of understanding (especially about my own culture) that I regard differences as an asset, not an obstacle. To a majority of people interfacing with foreign colleagues, the learning curve can be steep and sometimes even a game changer. Communication can’t be overdone in order to neutralize differences. Some Clients take the battle upfront and hire a cultural coach to break down barriers others believe in learning by doing. In any case, the issue should be high on the agenda during pre-selection. Often it turns out that differences in company culture and personal profiles are just as important to address (before, during and after establishing a partnership)
Provider organizations interface with a variety nationalities and business cultures on a daily basis, and for experienced Providers, the business culture, as well as the hired staff, reflect the ability to adapt to a new Client. Most often the transition towards a new way of working is on the Client organization. It can easily take 2-3 years for a client organization to complete a transition, i.e. a “hidden cost”
Layoff and Redundancy costs
It is very dependent on national culture and company culture if the Client includes layoffs and redundancy in the strategy. What is right or wrong is not for me to decide, but some organizations decide to take any battles upfront others to work out the problems. In both cases there are most often unforeseen and “hidden costs” involved in identifying severity, actions to be taken and not to forget any consequences of one or the other policy.
Starting a collaboration small and slow is by many regarded as best practice. A decade ago it was almost a mandatory part of an outsourcing startup. Mostly because the quality of the pre-selection was lower, both parties used is as an extended “due diligence” and a way to estimate if the collaboration should continue or not. Often pilots are chosen in such a way that nothing can go wrong in the case of failure. In my two decades in the industry, I have not seen a collaboration canceled due to a pilot. On the other hand, I have seen a lot of energy put in pilots that never added any kind of value to the clients business, never showed any collaboration metrics, and in some cases actually created the worst way of establishing a good collaboration environment and startup of a partnership, simply because not a single person were taken seriously, challenged as in real life or appreciated for work well done. Personally, I regard a pilot as a redundant cost, others would call it a “hidden cost”.
Even though it can be difficult for the Client organization to estimate the future needs, the strategy should include a vision for ramping up. Not only will such a plan indicate to the Provider about the Client intentions and affect pricing levels, it will also add actionable tasks to be prepared in both organizations in due time. To some organizations, the constant evolution of the collaboration is regarded as a “hidden cost”.
Intellectual Property protection
If you have IP to protect you want to make sure that the legislation of the outsourcing country of your outsourcing partner is within the necessary legal frames. Indicators can give a good hint in the analysis phase, but an international lawyer is a necessity before you sign a contract.
Cybersecurity is a risk that increases in the very moment a new data channel is established between one or more parties. The risk has to be evaluated before, during and eventually after a collaboration. The risk increases Globally, nationally, in the Provider organization as well as in the Client organization. In the pre-selection of a provider, the cybersecurity threat/risk on a global and national level can be evaluated based on indicators.
Even though your outsourcing partner will do whatever is in the organization’s power to screen the Client from any kind of bribe, indicators can be used during pre-selection to ensure that the level is within the frame of the Client CSR policy. Often the bribe level is a true hidden cost and the only way to foresee problems is by using global indicators.
Sometimes we forget that the world is not as globalized as we think, and collaboration between people of different nationalities can be hindered by as simple things as a VISA or the color of the passport. If physical co-location is a necessity in order to outsource a task (and in many cases it is), the pre-selection of a vendor should definitely include this important parameter.
What are the efforts to get a VISA for external employees, how long will it take, price, and how long can they stay?
What are the efforts to get a VISA for own employees, how long will it take, price, and how long can they stay?
A very simple question to ask: “would I invite my own family on a trip to this country or city?”.
As a leader, you would never position yourself in a way that you would jeopardize the life of yourself or your employees in case you need to visit your outsourcing partner.
Factors as Terrorism and Organized Crime levels should be part of the pre-selection criteria’s to avoid hidden security costs. Personally, I have visited countries and cities with both a high crime rate and the threat of terrorist attacks. The “hidden costs” in these cases were professional bodyguards.
During the pre-selection phase, it should also be evaluated if the Client organization is directly or indirectly responsible for security measures to protect a remote team of employees or Client assets (software or hardware), the “hidden costs” estimated to ensure corporate security standards. It should also be estimated if a temporary shutdown of a remote department is likely to happen and the “hidden costs” in such a worst case.
In some countries, it is quite usual to have armed guards. This is somehow an indicator that “hidden costs” might occur.
When Clients have a CSR policy that needs to be followed by a partner one could argue that this topic is a “hidden cost” in the analysis and pre-selection phase.
The transport infrastructure between Client and Provider can be a “hidden cost” if not accounted for during pre-selection. Are there direct flights that can reduce travel time, are there many scheduled flights per day/week and what is the pricing level to visit a partner.
Another issue is the local transport infrastructure. How much time do the employees need to travel in order to get to work? If 4 hours is needed per day there can be “hidden costs” due to fatigue and delayed arrivals at work.
Electricity, telephony, and Internet infrastructure
Power surges are common in many places of the world. Providers usually ensure themselves and Clients with alternative power sources, but “hidden costs” can occur due to temporary as well as long-term power surges.
To many Clients, it can be a surprise that the internet bandwidth between the parties is too low to accommodate reliable back-up of servers and online collaboration using corporate standard tools, etc. “Hidden costs” can occur if the pre-selection don’t include these technical aspects.
Inflation and exchange rates
Contracts are usually made in US$, EURO, UK£ or one of the major currencies, but national economies, as well as macro economies, can change overnight in a way that jeopardizes the partnership. Brexit is a very good and recent example of contracts that needed to be changed in order for the Provider to survive. Major changes can be hard to predict but steady inflation and exchange rate indicators should be considered during the pre-selection.
Having access to a skilled workforce is one of the very reasons for outsourcing. The education quality level and the number of yearly graduates can, directly and indirectly, be a “hidden cost” both in the short and the long term. The lack of corporation between a Provider and local universities can also affect the ability to attract the right employees.
A diversity of tax schemes exist worldwide, and contracts should always be very clear about who is paying what, when and how. Many governments have introduced free trade zones with special tax rates in order to help the local IT industry. “Hidden costs” can occur directly/indirectly overnight in case these tax schemes change. Especially Clients with offshoring setups where employees are hosted by the Provider and indirectly paid by the Client are vulnerable and hit with immediate effect in the case of changes.
An unstable government or policy in the destination country can introduce “hidden” and unexpected costs overnight. Tax rates are one example but worst case scenarios are embargos instability that makes the collaboration impossible.
There can be embargos of different nature between the countries of the Client and the Provider. Some products and use of technologies can be part of an embargo. It is only rare cases where an IT Provider has to be de-selected due to these circumstances, but in some cases “hidden costs” can occur in order to find out.
There can occur changes in existing trade tariffs or introduction of new tariffs including outsourcing services. This can occur due to change or political instability in both providers as well as Client country. This can definitely be regarded as an unforeseen cost or a “hidden cost”.
Burden of customs procedures
Having the need of shipping special production equipment, products and servers to the Provider premises can be hindered by customs procedures. It can both be costly and timely to export goods to some countries. A typical “hidden cost” when it occurs.
Flexibility of wage determination
Some countries have minimum wages imposed by the government, tariffs imposed by employee unions or directly/indirectly rules on lowering/raising salaries. The flexibility and determination of wages can impose “hidden costs” or even incompatibility with corporate policies.
Hiring & Firing Practices
Costs to enroll a skilled workforce can in some countries introduce “hidden costs”, i.e. upfront enrollment payment, fees to speed-up fast transfers, etc.
Firing practices often include strict rules on criteria, timing, and compensation. This is a “hidden cost” that especially Clients with dedicated teams on the payroll should be aware of.
There can be contractual costs to either a single employee or to the provider in case that one or more team members become redundant or the partnership has to come to an end. Usually, these conditions are written in the contract, but in some cases, they are only written as a clause with a reference to national regulations or third party rules. This can turn into a “hidden cost”
Country capacity to attract & retain talent
Not only the Provider should do an effort to attract and retain talent. On a country level, there are also, and almost always political initiatives to attract and retain talent. National indicators can be used in the pre-selection phase to reduce “hidden costs”.
Whenever a Client establishes a dedicated remote team or partner with an outsourcing partner for a specific task it is necessary to investigate legal rights on all levels. Unless the Client has the internal competencies and capacity to handle international law, the need of an external layer is often regarded as a “hidden cost”
The needed business sophistication level on a country level is often investigated during the pre-selection phase, and on Provider level during a tender or engagement process. This can be regarded as a “hidden cost”
Some countries and provider companies have attrition rates exceeding 20-25%. Depending on the outsourced tasks a high attrition rate can have a huge influence on productivity as well as capability to maintain a software base or product. It is very wise of a client to investigate attrition rates for a given provider during the pre-selection phase. Often a third party is needed to audit the figures, and this can be regarded as a “hidden cost”.
University – Industry Collaboration
As previously stated it is important that the Provider can attract the best graduates as well as interns. Sometimes the Client brand is completely unknown in the provider country. Even world leading brands can be totally unknown due to missing export to the provider country, and this makes it even more important that the Provider is, or have the potential to become a brand that can attract the best of the best.
When choosing a mid-size provider it can also be a good idea to chose a location where one or more alternative providers can deliver similar services (plan-B) and/or the outsourcing provider collaborate with other vendors in the region/cluster that are specialised in other technologies or verticals that might be needed in the future by the Client.
It can be regarded as a “hidden cost” to future-proof a setup during the pre-selection and enable future needs of multisourcing.
Soundness of banks
It can be regarded as a “hidden cost” to ensure that the banking sector in the provider country is sound, reliable and capable of handling the transactions needed between the Client and the Provider. Sometimes Clients are surprised to find out that their bank doesn’t make transactions with banks in a specific country or the bank of the provider. In these (rare) cases “hidden costs” can occur directly/indirectly as a third party is needed to ensure the transactions and unexpected fees need to be paid on a regular basis.
Productivity can greatly be reduced due to workday incompatibility.
Office working hours vs. Timezone
The collaboration between the Client and the Provider is almost always needed on a daily basis. Having a time-window for meetings and general collaboration activities is mandatory. When choosing a Provider it should be considered how large a time-window within normal business hours are needed. At an extra cost or inconvenience, the window can be put outside normal working hours, but for most partnerships a 1-3 hour window is needed as a minimum. Waiting on answers, requirements, results or stalling a question can have a great impact on the productivity. This factor is among the top-5 most important “hidden costs” that need to be addressed during the pre-selection of a provider.
Some clients offer their employees flexible working hours. Usually, employees in this organizations are just as flexible, but a long-term partnership with a foreign partner can affect the flexibility granted by the provider. This can result in less motivation, less productivity and in worst case employees resigning.
Holliday, Vacation, and workdays per week
Holliday and vacation periods are often forgotten and overshadowed as a “hidden cost” compared to the timezone issue. Some countries actually have near 100 days off per year which would have a huge impact on any kind of collaboration, not to talk about productivity. Compensations can sometimes solve the problem but in these rare cases, the Client would be better of de-selecting specific countries in the pre-selection phase. Similar problems can occur in case the Client and Provider organizations have holidays and vacations out of synchronization. This can often result in minimal productivity 20-40 days per year. This is a “hidden TOP-5 cost” that should not be forgotten.
Finally, some providers have a 6 days work week.
Outsourcing reduce costs by 70%
Large scale BPO service setups can hit these cost reductions figures if you do it right and need thousands of employees, but unless your organization is 3-4 generation outsourcing Clients a general figure of 20% is more likely and if you need to do major organization transformations in parallel, don’t be surprised if the first year will show a big round zero.
Outsourcing partners can’t Innovate
Only Client organizations that made shortcuts in the pre-selection phase came to that conclusion. In order for Providers to be able to compete and grow in an ever demanding ecosystem Innovation is high on the agenda. Providers specialize and work with technologies day in day out, that most Client organizations can’t compete with.
Advisory is too expensive
True, if you select an advisory partner in the same caliber as a fortune-500 company it might be out of your league and budget. Some advisory companies also specialize and disrupt the marked with top quality services especially targeted the majority of outsourcing clients in the need of 3 – 500 full-time employees. Some even offer on-demand pre-selection services and managed advisory services in the range EUR 4.000 – 10.000. With such a price tag advisory services is within reach of most Client budgets, and it will be hard for even experienced internal procurement teams to compete on neither price or quality.
“Killers” that will ruin you
Lack of knowledge
Entering a completely unknown field without accumulating knowledge in one way or the other is a killer factor.
Top-down decisions with a total disconnect between management and employees and without a clear overview of the operational challenges outsourcing would be to the organization is a killer factor.
The Sharks – Brokers
In the web industry, it is common to use agencies. Agencies are companies consisting of a core team specialized in specific technologies and platforms. Oftentimes they consist of a variety of employees specialized in front/back-end disciplines and are able to expand as needed with freelancers in order to complete a job.
Something totally different is companies only consisting of a sales organization with one aim only – to represent on or more outsourcing providers and on a commission based business model attract Clients and close a deal. You probably think of digital marketplaces for freelancers, and yes, they are Brokers – but at least they do their business upfront. These organizations cover a demand for short-term resources that can deliver one-off projects without the need of maintenance or other long-term aspects in mind.
The real ‘killers’ in the software outsourcing industry are Brokers pretending to be independent advisers. Some have closed deals with 10, 50 or even hundreds of Providers in order to present Clients what looks like marked research, but… the Client will never get the full transparency in the pre-selection, they will never know if it really was the best matching provider that was presented as a result of the “research”, they will never be informed about the hidden costs of the middleman and they will be locked into contracts where they in worst case have to fight not only the provider organisation but also the Broker organisation.
If you don’t pay a fee for advisory services – stay clear, YOU are the “product”.
Pre-selection services from a Broker
If the “adviser” only makes a rudimentary analysis of your long-term needs from a one hour interview, your organization challenges and don’t show you exactly why a specific country or provider was the best choice for your organization – stay clear, YOU are the “product”.
If you furthermore are offered “advisory” services for free – stay clear, YOU are the “product”.
You will maybe be presented what on paper seems to be a minimisation of the Client’s risks by letting the middleman secure your payments, but nowadays 90% of all providers have excellent banking partners – those who don’t shouldn’t be considered anyway. If the Client read the small letters in the contract the Broker is not taking on any kind of risks at all. The only reason offering an escrow service is to control a stake in the monthly invoices and hide the commission fee. – stay clear, YOU are the “product”.
Global pricing levels
You will maybe be presented global pricing indicators based on “thousands” of provider list prices as if these prices would be the same as if you approached the provider on your own – be sure, they are not. Be sure the prices always include the commission fee. – stay clear, YOU are the “product”.
Lack of Operational services
If you are not offered any kind of operation services as R&D management services or onshore developers it is quite obvious that the only thing you get is a sales service – but hey, you are the Client, so this service was not exactly in your favor – stay clear, YOU are the “product”.
10 – 20% Commission fees
Even though the trend of Clients having cost reductions as number one priority is diminished by a higher priority on skilled resources, flexibility, focus on the core business, etc. all Clients without exception has expectations of savings.
Using a Broker is not exactly the best start. Brokers have a variety of business models, but the most common are one-year contracts with a 20% commission fee or three-year contracts with a 10% commission fee from each invoice. If you take the myth buster recommendation into account, exactly this fee can be the turning factor to stay well below a break even.
So, even though you start slowly with a small pilot project your expenses on long-term are devastating.
Not only do these fees have a magnitude comparable to what can be saved on automation, it is plain and simply bad for business. To some extend Brokers were needed a decade ago due to lack of global information on the mid-level marked, and no specialized advisers to turn to, but these days are long gone.
One could argue that the fee is deducted from the Providers revenue, but even if that was the case, you have as Client, and from the very beginning entered a partnership where you have diminished all the sentiments of a good business relationship with the provider.
Providers will also have an increasing problem explaining themselves and their list prices when independent advisory companies show differences compared to the Broker list prices.