In Depth: When Outsourcing Goes Bad

Companies have been burned by outsourcing. That has taught some hard lessons.

In its complaint, Sprint claims IBM failed to achieve contractually agreed upon productivity gains. The carrier wants IBM to provide an additional 119,000 hours of work free of charge and is seeking damages of not less than $6.4 million. Sprint CIO Richard LeFave, who replaced Stout after the merger with Nextel, declined to be interviewed.

At MeadWestvaco, CIO Jim McGrane sought a realistic appraisal of what his company was getting for its internal IT spending before trying to bid that work to outsourcers. MeadWest-vaco performed a thorough cost evaluation of all services performed by its tech staff. "We went through and defined our service catalog, and we defined the cost of delivering each service," McGrane says. To obtain objective measurements, the company benchmarked its results with those published by the Hackett Group consultants. "If you know what you have, you're in a much better position to achieve a contract that doesn't bite you," McGrane says. This year, his company handed a range of IT functions to Affiliated Computer Services.

With so much at stake, failed outsourcing deals can easily end up in court. Sears Holdings, the corporate parent of retailers Sears and Kmart, and Computer Sciences Corp. are still locked in a legal battle to settle the status of a 10-year, $1.6 billion IT services contract that Sears walked away from in early 2005, after just one year. Sears says it tore up the contract "for cause" but won't elaborate. CSC sued for damages, complaining that a corporate restructuring left Sears with a new management team that wanted nothing to do with outsourcing. According to Sears' most recent quarterly SEC filing, the two parties have agreed to "voluntarily mediate their disputes." At stake for Sears are millions of dollars in termination fees that it would have to pay CSC if a court rules it improperly ended the contract. CSC says it may not be able to recover investments made in Sears' infrastructure if it loses the case--an amount that could be as high as $100 million, according to Moors & Cabot analyst Cindy Shaw.

Deals Are Long-Lived

Outsourcing carries a long-term, big-ticket financial commitment, so major deals need board-level scrutiny. Just like building a new factory, they can outlast the executives who broke ground. Sears' contract with CSC was fashioned under CIO Gerald Kelly, who was out after last year's merger of Sears and Kmart. Kmart CIO Karen Austin got the top technology post at the combined company. It became her job to look for an exit from the CSC outsourcing deal.

Outsourcing-s like a bell curve, Worldspan-s Powers says Photo by Stan Kaady

Walking away from a deal early can cost a company dearly unless it can prove that the outsourcer was failing to live up to key terms in the contract. William Bierce, a New York attorney who specializes in outsourcing law, says he worked on a contract in which the penalty for early termination was $60 million. Typically, termination fees increase every year in the early years of a deal because, at that point, the vendor is investing heavily in PCs, servers, and software on behalf of the customer. But Bierce says filing a lawsuit should be a last resort because of the public scrutiny it brings to a company's operations. "Disputes with service providers are extremely sensitive because they highlight the dependency of the enterprise on the service provider," he says. "And anything that highlights a dependency is fair game for shareholders' attorneys and class-action lawsuits."

Sears has good reason to try to hammer out an amicable agreement with CSC, which continues to provide the retailer with IT services until the dispute is resolved. In its annual report, Sears suggests the imbroglio could create operational risk. "Given the number of individual transactions we have each year, it is critical that we maintain uninterrupted operation of our computer and communications hardware and software systems," the report says.

One company that handled a similar situation more adroitly is JP Morgan Chase. When it merged with Bank One in 2004, Chase execs decided to take advantage of the significant investments that Bank One already had made in its internal IT infrastructure and thus backed out of a $5 billion outsourcing contract with IBM.

Instead of mutual recrimination, however, the companies worked out a transition plan that saw Chase retake control of its outsourced operations and move 4,000 tech workers back in-house. IBM went so far as to issue a press release pledging to help the bank repatriate Chase's tech operations.

Paul McDougall is a former editor for InformationWeek. View Full Bio