Guide to ICT Sourcing - Appendix A: Economic Diagnosis Tool
Appendix A: Economic Diagnosis Tool
- Question 1: What is the invoice cost of the arrangement?
- Question 2: What would be the equivalent cost in a fully self-managed scenario?
- Question 3: What explains the difference in cost-to-serve?
- Question 4: What termination costs do I have to take into account?
- Question 5: What is the real cost of outsourcing overall?
- Question 6: Would I be better off self-managed?
To complement this guide, this economic diagnosis tool will help agencies understand the real value of an arrangement with an outsourcer. The logic of the tool is described below to show how it works and also to underscore the value of taking this type of analytical approach.
The tool is described from the perspective of an agency whose current ICT sourcing strategy is external. This means that:
- agencies that have an external sourcing strategy can apply the tool directly
- agencies that self-manage ICT can apply the logic of the tool to understand their arrangement and to compare it to the alternatives, but they may need to reverse the order of some steps in the model.
The economic diagnosis tool is an essential aid to Phase I of the sourcing lifecycle. The purpose of the tool is threefold. First, it will help agencies understand the real value of their current sourcing contract, including the discrete sources of value. Second, it will provide a reference point for assessing alternatives. Third, it will help define the expectations of the next sourcing strategy and focus it on the most relevant options.
The tool is structured around six important questions relating to the real value of a sourcing contract (Figure 26). The assessment uses a yearly snapshot of the economic costs for the past year.
Figure 26: The real value of a sourcing contract
Figure 27 shows how these questions relate to the perceived value and real value calculations described earlier in this guide.
Figure 27: Perceived value and the real value calculations
Question 1: What is the invoice cost of the arrangement?
The invoice price from the vendor will provide the basis for calculating the perceived value of an arrangement (Figure 28).
Figure 28: Calculate the real value of the arrangement
Question 2: What would be the equivalent cost in a fully self-managed scenario?
Agencies can use three approaches to answer this question:
- A top-down approach using benchmarks: Consider a simple example of an agency whose primary ICT requirement is the operation of PCs. If the agency’s overall ICT cost for self-managing PCs is $7000 per PC, and if benchmarks or best practices from other agencies indicate a comparative cost of $5000, the agency could assume the alternative scenarios offer a perceived value of 28 per cent ($2000 of $7000).
- A bottom-up approach that rebuilds the existing ICT infrastructure: In this approach, agencies would rely on new market prices and current knowledge about practices and costs. Using the example above, the agency would disaggregate all the cost components involved in operating PCs, and then seek current market prices on each component. Based on the potential cost of these components, the agency would build up an overall cost of operating PCs, multiply by the number of PCs, and compare this with the current cost. The difference represents a broad estimate of perceived value of an alternative. For this approach, agencies should reference cost data. An example is shown in Table 5.
- A mixed approach that combines top-down and bottom-up analyses: Here, agencies would go beyond the basic top-down approach, but not as far as a detailed bottom-up approach, by looking at the major elements of ICT and comparing them to benchmarks. Agencies would understand perceived value and how that relates to some of the main categories of ICT spending, but the analysis would not have the same level of granularity as a more time intensive bottom-up assessment.
Table 5: Example of outsourced cost assessment in a bottom-up approach
Question 3: What explains the difference in cost-to-serve?
The value of the arrangement comes from the difference in the cost-to-serve between the vendor’s offer and the self-managed option. As discussed earlier, four major components account for this difference – three types of benefit are partially offset by the vendor’s margin to yield the perceived value of the arrangement.
Agencies need to disaggregate perceived value, regardless of how it was calculated, into its four drivers of scale and cost position, quality and efficiency, risk exposure, and vendor margin. The specific cost elements that typically make up these drivers are described in Figure 27. With this breakdown complete, agencies should have a clear picture of the magnitude of perceived value, along with its key sources.
Question 4: What termination costs do I have to take into account?
Termination costs represent the cash outlay an agency would incur before moving to another sourcing option; they do not include the costs that would be associated with transition to the alternative.
A conservative estimate is that termination costs are typically between 15 and 60 per cent of the annual invoice price. This is generally due to unexpected issues with intellectual property rights, residual value of equipment, transfer of assets or remaining lease payments, assistance from the incumbent vendor to transition to a third party, and any potential damage costs. The top figures of the range generally occur during a difficult transition to the next sourcing arrangement, early termination (before end of contract), or when equipment has recently been refreshed.
If termination costs have been managed during the contract, there should be no surprises in the lead up to renewal. For instance, if an agency is relying on the vendor to develop and customise a specific application that runs the vital functions of the business, termination costs – if left unmanaged – could be significant. A termination strategy should ensure the vendor’s control over this application progressively diminishes long before the end of the contract.
Question 5: What is the real cost of outsourcing overall?
This calculation describes the difference between the face price (and perceived value) and the real cost (and thus the real value). It should capture all the costs that would not be incurred if there were no contract; for example, the cost of ongoing contract management, and the expected termination costs spread across the duration of the contract. The components of this analysis are shown in Figure 28.
The calculation is made on an annual basis using the current-year information. It assumes that the current year is representative of the average year for the contract.
The sources of information are the historical data for the transition costs, the current accounting information for the management costs, and an estimate, based on the contract, for the termination costs. Agencies can use the checklist in Figure 29 to look for the information.
When detailed historical information for transition costs is not available, which often happens, an estimate needs to be made.
Figure 29: Components of outsourced cost analysis
Question 6: Would I be better off self-managed?
If the self-managed estimate is close to the current real cost of the proposed arrangement, this option should be considered as an alternative (Figure 30).
At the end of the data gathering, when adding all the elements, a sensitivity analysis is useful to stabilise the overall results. It allows agencies to identify the cost drivers that would have the biggest impact on the total value and therefore refine them if the estimated range is too wide.
Figure 30: Components of a self-managed cost analysis
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