Since the early 1990’s, outsourcing has developed into a critical method for businesses to optimize the value of the information technology (IT) function. Gottshalk and Solli-Sæther (2005) describe IT outsourcing as, “the practice of turning over all or part of an organization’s IT functions to an outside vendor” (p. 685). Businesses seek to outsource the IT function in an attempt to deliver increased cost-efficiencies that enhance the bottom-line without sacrificing IT capabilities. As Gottshalk and Solli-Sæther explain, “Client companies [that outsource IT] reported reduction of costs, better cost-performance, and economies of scale, compared to internal IT function” (p. 695). Weimar and Seuring (2009) identify an additional motivation for IT outsourcing, namely that it allows the business to, “focus on core business activities and development of competitive advantage” (p. 277). Koh, Ang, and Yeo (2007) found that markets evaluate a company’s value more highly when the business outsources information technology functions. Outsourcing enables IT to deliver value to the business at lower costs and enables the business to focus on core-competencies; meanwhile, markets value companies that make the right strategic outsourcing decisions.
Since most organizations utilize service level agreements (SLAs) to manage internal IT functions, SLAs are a natural choice for managing external IT. However, Martorelli (2009) describes significant flaws associated with using service level agreements to manage outsourcers. Outsourcing agreements that utilize SLAs as the primary performance management tool often result in antagonistic business-vendor relationships. In addition, penalty clauses are difficult to enforce (Martorelli, 2009).
Businesses seeking to achieve a beneficial outsourcing arrangement with a vendor need an alternative means of managing the relationship. Gottshalk and Solli-Sæther (2005) identify eleven critical success factors for IT outsourcing, including, “vendor behavior control.” (p. 694) Gottshalk and Solli-Sæther describe “vendor behavior control” as including the use of “outcome-based and behavior-based incentives […] to reduce and prevent opportunistic vendor behavior.” (p. 694) By implementing outcome-based and behavior-based incentives, the business mitigates the risks associated with SLA-based management and encourages vendors to adapt behaviors that align with the company’s vision and strategies.
A review of the literature on information technology outsourcing, behavior- and outcome-based management controls, and balanced scorecard to develops an understanding of the effectiveness of balanced scorecard as a performance management tool for IT outsourcing relationships.
Outsourcing and IT Delivery
In the book, “Multisourcing: Moving Beyond Outsourcing to Achieve Growth and Agility,” Linda Cohen and Allie Young (2006) define outsourcing as, “contracting with an external firm for the ongoing management and delivery of a defined set of services to a prescribed level of performance” (p. 2). Cohen and Young describe outsourcing as a critical success factor for businesses seeking to compete in the modern, global marketplace. Cohen and Young attribute the growth and popularity of outsourcing to Hamel and Prahalad’s writings on core competencies in Harvard Business Review and Champy and Hammer’s book, Reengineering the Corporation. (Cohen and Young, 2006). According to Cohen and Young, these management strategies, combined with demand for scalable, cost-effective service delivery in the 1990’s resulted in the development and maturation of outsourcing as a management strategy for service delivery (Cohen and Young, 2006).
The view of outsourcing as an important strategy for delivery of non-core information technology services is further reflected in Ward and Peppard (2002), “reducing the organization’s commitments to systems [that are not critical to an organization’s future] can be achieved in a number of ways [including] outsourcing their operation and support” (p. 329). Ward and Peppard see outsourcing as a key aspect of managing a company’s information systems portfolio (Ward and Peppard, 2002).
In their 2005 literature review, Gottshalk and Solli-Sæther found that core competencies theory was one of several theories relevant to IT outsourcing, in concurrence with Cohen and Young’s claims. In later research, Solli-Sæther and Gottshalk operational-ized their previously identified critical success factors and evaluated the relative contributions to a three-stage outsourcing maturity model (Gottshalk and Solli-Sæther, 2006; Solli-Sæther and Gottshalk, 2008). Solli-Sæther and Gottshalk’s three-stage model describes a maturing outsourcing relationship moving from cost to resource to partnership stages. Solli-Sæther and Gottshalk found that, “in terms of economic benefits, cost minimization and operational efficiency belonged,” to the cost stage (Solli-Sæther and Gottshalk, 2008, p. 646). Solli-Sæther and Gottshalk also found, “vendor behavior control was statistically significant by cost stage being associated with service level agreement and cost” (Solli-Sæther and Gottshalk, 2008, p. 646).
Koh, Ang, and Yeo (2007) found that the marketplace values information technology outsourcing in an examination of 420 IT outsourcing announcements by publicly traded companies that showed positive short-term stock returns related to the outsourcing. Koh, Ang, and Yeo’s results show that the market places value on outsourcing above and beyond popularity with business management.
Clearly, outsourcing is an important, market-approved option for business leaders responsible for the delivery of IT services. When properly executed, outsourcing offers businesses an opportunity to, “accelerate time to market, manage growth, and gain access to hard-to-find and expensive skills,” while also providing, “a cost-saving quick fix when budgets [come] under pressure” (Cohen and Young, 2006).
Service Level Agreements
Managing Outsourcing with Service Level Agreements
Service level agreements, also known as outcome-based measures, describe the delivery of information systems functionality using performance metrics that both IT and the customer acknowledge. In the book, “Smarter Outsourcing: An executive guide to understanding, planning, and exploiting successful outsourcing relationships,” Bravard and Morgan describe, “the two key attributes of SLAs is that they
should be controllable and that they should continue to reflect real business
needs, rather than becoming a business activity in their own right” (Bravard and Morgan, 2009, p. 73) Cohen and Young similarly stipulate the importance of SLAs as a reflection of business needs. Cohen and Young also warn that SLAs may also limit the business. For example, Cohen and Young describe a business need, “process invoices within 72 hours,” that gets translated into a more limited service level agreement, “process 80% of invoices within 72 hours” (Cohen and Young, 2006, p. 162). The SLA provides a metric that can be used to benchmark, monitor, and manage IT investments and ensure business needs are met. In the context of outsourcing, SLAs also include penalty clauses that detail the expectations in the event that an SLA is not met.
Ward and Peppard describe SLAs as well recognized for delivery of services such as, “network uptime, response times and help-desk support” (Ward and Peppard, 2002, p. 524). Most organizations have developed internal service level agreements as part of their IT management strategy. As companies consider and engage in IT outsourcing arrangements, service level agreements are a natural tool for managing the contract. As Martorelli explains, “Virtually all of the outcome-based outsourcing contracts that Forrester Research has reviewed pay at least some attention to SLA targets and associated penalties” (Martorelli, 2009, p. 1). SLAs represent a major tool for managing outsourcing contracts.
Limitations of Service Level Agreements
Outsourcing requires one company, the outsourcer, to trust another company, the vendor, with critical IT business capabilities. Clearly, the outsourcing relationship must be carefully managed to ensure that the outsourcer achieves the desired beneficial business outcomes. Many firms utilize service level agreements (SLA) to ensure vendors meet the obligations of the outsourcing contract. However, as Martorelli (2009) describes, SLA’s are often inadequate, “service-level agreement (SLA) penalties provide poor compensation for unsatisfying outsourcing relationships” (p. 1). Martorelli (2009) continues to explain why service level agreements often fail to produce satisfying results,
Outsourcing suppliers indicate that despite having significant sums at risk in the context of overall contract value, little money is ever “paid out.” Suppliers rightly boast about their strong performance against SLA targets, but the reality is that typically generous earn-back provisions would likely neutralize any real economic penalty. Faced with the burden of measurement, analysis, and root cause analysis before contractual penalties kick in, it is not surprising that at the end of the day limited monies ever change hands. (p. 1)
Aggressive enforcement of service level agreements by outsourcers results in vendors demanding contract renegotiation and an antagonistic relationship between outsourcer and vendor (Martorelli, 2009).
Managing Outsourcing with Balanced Scorecard
One of the critical methodologies for behavior-based performance management is the balanced scorecard. Originally introduced by Kaplan and Norton in a 1992 Harvard Business Review article, as a method for managing business unit performance, balanced scorecard provided an operational view of an organization from four perspectives: financial, customer, internal business process, and learning and growth (Kaplan and Norton, 1996). The balanced scorecard is “balanced” in the sense that the four perspectives provide a holistic view of the organization. The balanced scorecard is a “scorecard” in the sense that the organization develops measures to evaluate and benchmark each perspective in relation to business goals. The balanced scorecard provides an improvement over traditional financial management because it incorporates traditional lagging economic indicators as well as leading indicators (Kaplan and Norton, 2001b). As the balanced scorecard methodology has matured, it has been extended from business unit performance management to strategic alignment (Kaplan and Norton, 1996; Kaplan and Norton, 2001a; Kaplan and Norton, 2001b; Kaplan and Norton, 2001c).
One major factor for balanced scorecard’s proposed value as a strategic management tool is the incorporation of a means of valuation for intangible assets, which traditionally are difficult to assign a value (Kaplan and Norton, 2001b; Ittner, 2008). Intangible assets include human resources, database systems, and other aspects of the business that are not directly reflected on the financial statements, but may provide value. While Kaplan and Norton describe the balanced scorecard framework as a means of viewing intangible assets via a measure “other than currency,” Ittner identifies several flaws in current methods of intangible asset valuation, including balanced scorecard (Kaplan and Norton, 2001b, p. 89; Ittner, 2008). Ittner finds no statistically significant benefit for companies utilizing balanced scorecard for intangibles valuation compared to companies using a different method (Ittner, 2008). In terms of outsourcing, intangible assets may be the efficiency of a potential outsourcers processes or the level of experience of staff.
Somewhat ironically, one of the principal outcomes of the transformation of Kaplan and Norton’s system for managing business unit performance into a framework for strategic business management is that business leaders recognized an opportunity to leverage the balanced scorecard to manage outsourcer performance – from performance management to strategic governance and back to performance management.
As Weimer and Seuring (2009) state, “The balanced scorecard (Kaplan and Norton, 1992) plays a dominant role within current management accounting and controlling research and is considered as the preferred performance measurement system (Malina and Selto, 2001)” (p. 277) .
Weimar and Seuring (2009) describe balanced scorecard’s application as an outsourcing management tool,
The balanced scorecard is defined as a controlling tool that is particularly suited to implement corporate strategies and to link operational and strategic governance (Kaplan and Norton, 2004, 1992) and can therefore be described as a strategic controlling tool. Consequently, the balanced scorecard can also be considered as a potential outsourcing controlling tool that supports the implementation of the corporate outsourcing strategy and thereby governs and controls the external provider (p. 278).
It should be noted that “controlling” in the sense used by Weimar and Seuring is equivalent to “management accounting,” similar to the business role of a controller. Weimar and Seuring identify a relative gap in scholarly research related to outsourcing given the popularity of outsourcing as a business strategy (Weimar and Seuring, 2009). In a study of four case studies utilizing balanced scorecard to manage outsourcing agreements, Weimar and Seuring find, “the balanced scorecard characteristics represent under certain conditions an appropriate performance measurement system in the outsourcing context with the underlying compensation model being the major determinant for their applicability as it basically drives the characteristics of performance measurement systems in the outsourcing context” (p. 288). Thus, Weimar and Seuring find that, where balanced scorecard is compatible with the financial aspects of a contract, it serves as a suitable means of managing the outsourcing contract.
Benefits of Balanced Scorecard
The primary benefit of balanced scorecard when compared to service level agreements is that Kaplan and Norton’s framework addresses the outsourcing from a strategic, holistic point-of-view. As Paranjape, Rossiter, and Pantano (2006) state,
The traditional performance measurement systems based on financial metrics alone have been deemed inadequate and more attention is being paid to non-financial metrics. Several broader performance measurement systems have been designed, of which Balanced Scorecard (Kaplan and Norton, 1996) has been the least criticized and most widely accepted (p. 5).
One benefit of the balanced scorecard is that it is a behavior-based measure. As a relationship, an outsourcing agreement will fluctuate over time. As Epstein and Rejc (2005) state,
Performance measurement systems have to be modified as circumstances change, just like strategic objectives are modified according to the new strategy, drivers are revised, and new causal linkages among drivers are determined (p. 39).
Effective management of the outsourcing contract requires a flexible system. Outcome-based controls like service level agreements have limited flexibility (e.g., there is little that can be varied in a measure like 99.9% network uptime). Behavior-based measures can incorporate outcome-based components, but focus on incentivizing desired behaviors.
Another benefit of using balanced scorecard to manage outsourcing arrangements is that Kaplan and Norton’s framework enables a straightforward value chain analysis of the contract. In the 2005 article, “How to measure and improve the value of IT,” Epstein and Rejc (2005) propose a balanced scorecard framework tailored to IT. According to Epstein and Rejc, the balanced scorecard provides a means for understanding and realizing hidden value from within the IT value chain. Following the logic laid out in Kaplan and Norton’s 2004 article on valuing intangibles, Epstein and Rejc perform a value chain analysis on the IT function to demonstrate the business benefits of balanced scorecard performance management of IT (Epstein and Rejc, 2005; Kaplan and Norton, 2004). Epstein and Rejc’s results for IT parallel Barber’s findings for business use of balanced scorecard in determining value chains (Epstein and Rejc, 2005; Barber, 2008). Value chain analysis using balanced scorecard provides a richer, more meaningful view of the outsourcing relationship than a simple outcome-based measure like SLAs.
Sharma (2009), Buhovac and Slapnicar (2007), Assiri, Zairi, and Eid (2006) all identify balanced scorecard as useful, but very complex to implement effectively (Sharma, 2009; Buhovac and Slapnicar, 2007; Assiri, Zairi, and Eid, 2006). Ittner (2008) and Buhovac and Slapnicar (2007) are unable to distinguish a statistical difference between the results of balanced scorecard and other systems (intangibles valuation for Ittner, alternative performance measurement systems for Buhovac and Slapnicar), suggesting that more research is needed to understand balanced scorecard’s relative popularity (Ittner, 2008; Buhovac and Slapnicar, 2007). As Paranjape et al. (2006) describe,
A high rate of failure and many practical difficulties however, are associated with the implementation of BSC. There is further scope for research in ‘‘design of performance measures’’ as the problems faced in selection and operationalisation of performance measures are well documented in literature (p. 5).
In addition, Paranjape et al. identify an additional need for research into process management systems that more directly address the needs of global virtual teams,
For a world-class performance it is important that the global processes, virtual teams and individuals within the teams in these multinationals, work in a smooth and integrated manner. Performance can be greatly enhanced if there is timely (often real-time) reporting, instant feedback, quick decisions and immediate actions. These radically different, ever changing process-team-individual structures have created a new and growing field of study, but there is currently very little in the literature on performance measurement in relation to global organizations (p.10).
While balanced scorecard stands out as the most popular and least criticized means of managing strategic performance of outsourcing agreements, additional research is needed.
Outsourcing has developed into a critical component of IT delivery and business strategy. Businesses seeking to be competitive in the global marketplace must evaluate outsourcing as a strategic decision. Managing an outsourcing relationship is complex and requires the hybridization of multiple business strategies (at the very least, the primary business and it’s supplier) (Bravard and Morgan, 2009). Service level agreements have been found to be inadequate for managing IT outsourcing agreements (Martorelli, 2009). Balanced scorecard provides an alternate, behavior-based means of managing outsourcing agreements that provides improved alignment between business and supplier strategies and overall greater satisfaction. The four perspectives of balanced scorecard enable a holistic view of the business relationship with the outsourcing vendor that is not provided by outcome-based measures. Businesses engaging an outsourcer should consider utilizing balanced scorecard to manage the performance of the supplier.
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