The unseen risks of IT outsourcing

Ever wonder how, if something isn't good for you, it can be good for someone else?

The buzz is that IT outsourcing is a win-win situation. Large enterprises place the burden of maintaining, servicing and upgrading IT operations onto a third party, which in turn makes nice profits through economies of scale. But the recent debacle at WorldCom Inc. has brought to light questionable accounting practices at its IT provider, Electronic Data Systems Corp., and casts doubt on the financial arrangements that have made IT outsourcing agreements viable.

Because most IT outsourcing deals demand high upfront costs for equipment, network connectivity and personnel, the initial years of an engagement can mean huge losses for the IT provider. To mitigate this problem, EDS chose, in the case of its US$6.4 billion, 11-year contract with WorldCom, to employ percentage-of-completion accounting. That let EDS grow rapidly by booking some revenue before it was billed. It also let it spread over several years some of the expenses of setting up the IT infrastructure.

But the recent accounting scandals bring into question whether this method is a good way to analyze a company's financial performance. Besides making it difficult to figure out whether a particular contract is profitable, it places a huge amount of risk at the door of the outsourcing firm. And you have to wonder whether you can depend on your outsourcer.

How much longer can this last?

EDS pulled out of the bidding on an IT outsourcing contract for Procter & Gamble worth almost $1 billion per year, citing too much risk in taking over a majority of the consumer products giant's back-office operations.

Is this a warning shot for a review of IT outsourcing relationships? Outsourcing has been touted as an efficient way for companies to focus on what they do best while palming off the IT drudgery to someone else. But we're learning that the drudgery comes with some high costs and might not be so profitable for third parties without some financial maneuvers.

At the very least, the scandal should refocus the debate on whether IT expertise ought to be a genuine cost, built into the routine of running a business, and whether you can be immunized from the risks of maintaining an IT infrastructure just by signing a contract.

With uncertainty surrounding the accuracy of financial reporting, it's imperative that you know the risks your potential IT outsourcing firms have incurred. Ask who their largest customers are, learn how they plan to account for your business, and check if they're making money from their contracts. That's the only way to verify that win-win is more than a marketing slogan.

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