From Cost Management To Innovation and Business Value

Outsourcing:
FROM COST MANAGEMENT TO

INNOVATION AND BUSINESS VALUE
Michael R. Weeks
David Feeny
D
uring the past few years, innovation has become a headline
agenda item for many firms1 and for their CIOs.2 Can CIOs who
have outsourced most of their information technology (IT) meet
the challenge, or is outsourcing incompatible with innovation?
Certainly, losing innovative capabilities is recognized as a potential risk of out-
sourcing in these environments.3
IT outsourcing is now twenty years old and many large organizations
have a decade or more of experience in large-scale IT outsourcing relationships.
For these firms, the success of their relationships is critical, since switching sup-
pliers is extremely costly and painful, and a large-scale return to in-sourced
alternatives is seen to be almost impossible. “Success” is a multi-dimensional
concept: the most obvious goals are to achieve high-quality IT services at low
levels of cost; but the rhetoric of IT outsourcing has included an expectation that
a “world-class strategic partner” will also be a source of new ideas and practices,
leading to increased business value over time.4 It is in these dimensions of inno-
vation and “added value” that firms have most commonly been disappointed.
Consequently, our research has focused on how improved innovation outcomes
can be achieved.
Interpretation of prior research work does not suggest definitive conclu-
sions about the effect of IT outsourcing on innovation.5 Clearly, external per-
spectives and skills may contribute to innovation potential. However, increased
coordination complexities and a lack of alignment of risks and incentives may
make achievement of the potential more difficult. Our expectation was that IT
outsourcing in itself neither ensures nor negates innovation. Outcomes will be
dependent on key enabling factors within the relationship, which the research
set out to identify.
CALIFORNIA MANAGEMENT REVIEW VOL. 50, NO. 4 SUMMER 2008 CMR.BERKELEY.EDU 127
Outsourcing: From Cost Management to Innovation and Business Value
The Scope of the Research

Our research included four in-depth case studies, all involving large firms
in long-term relationships with prominent providers of IT outsourcing services.
Case 1
Client firm A is a leading engineering company, increasingly focused on
defense markets. It has annual revenues of more than $20 billion and extensive
operations in both the USA and Europe. Client A took the decision to outsource
most of its IT activity in 1993. It was a decision taken by the highest-level Group
Executives who were unconvinced that IT was a core competence and saw that
outsourcing would provide an immediate and much needed improvement to the
balance sheet. They also hoped that it would result in lower IT costs over time.
Their chosen provider was Supplier X, itself a major firm with current revenues
of more than $15 billion and an extensive client base across many geographies
and industry sectors. Supplier X took on the great majority of Client A’s IT oper-
ations—and 85% of its IT staff—in 1994, and remains Client A’s provider to this
day. However, the relationship has
Michael R. Weeks is an Assistant Professor of passed through a number of moods and
Management in the Sykes College of Business at the phases, and two contract renegotiations.
University of Tampa. <mrw@weeks2000.com>
The first of these, in 1996, sought to
David Feeny is the Director of the Oxford Institute of realign the contract to client business
Information Management and a Fellow of Templeton
College and the Saïd Business School of the objectives after an initial period marked
University of Oxford. <david.feeny@sbs.ox.ac.uk> by adversarial debates around contract
terms and expectations. The second
renegotiation, in 2000, was triggered by substantial changes in Client A’s busi-
ness configuration following major M&A activity. The opportunity was taken in
2000 to more formally express Client A’s expectation of an innovation contribu-
tion from Supplier X—an expectation that had been present from the start, but
was not being met to Client A’s satisfaction. Two years later, however, a down-
turn in market conditions led to new pressures from Client A to reduce IT cost
levels beyond the contract terms; and there was continuing ambiguity observed
in Client A’s view of the role and significance of IT, particularly at strategic busi-
ness unit (SBU) level. Nevertheless, Supplier X’s revenues from the relationship
had grown from around $200 million in 1994 to more than $750 million, and
Client A was reported to be the company’s largest single customer.
Case 2
The second case study involved a leading manufacturing concern and its
relationship with another of the major providers of IT outsourcing services.
Client B specializes in gas turbine technology for aviation and marine applica-
tions, and it has annual revenues of around $12 billion. Its IT outsourcing expe-
rience started in 1996 when its largest single business division transferred almost
all of its IT activity and staff to Supplier Y—an IT services firm with revenues of
around $10 billion—in a contract worth around $125 million per annum. As in
Case 1, balance sheet benefits from the transfer were again significant in the
128 UNIVERSITY OF CALIFORNIA, BERKELEY VOL. 50, NO. 4 SUMMER 2008 CMR.BERKELEY.EDU
decision making. By the middle of the current decade Supplier Y’s business with
Client B was worth around $400 million per annum, and they provided IT ser-
vices to all of Client B’s business divisions. However, the relationship had been
on something of a rollercoaster ride. Both parties agreed that it started well.
Supplier Y involved its consultancy arm, which operated across its eight Client
Industry Divisions, in a series of business process improvement projects that
delivered early benefits to Client B. However, by 2000 it was judged that the
technology infrastructure planned to support new business processes was mis-
aligned with the reality of pressures on Client B’s IT cost structure. A renegoti-
ated contract in 2000 provided Client B with further short-term financial
benefits, and Supplier Y with a contract extension. It also included mutual com-
mitment to a significant reduction in unit costs through rationalization of the
infrastructure, a project that led a year later to a further crisis when Supplier Y
claimed that Client B was failing to deliver on the company-wide standardiza-
tion on which such rationalization depended. At the time of the research inter-
views, the outlook for the relationship was in the balance, with recent changes
to the leadership of Supplier Y’s account team intended to restore a positive
climate.
Case 3
There are a number of parallels between Case 3 and Case 1. Client C is
also a prominent engineering group with an emphasis on defense markets; it
started to outsource its IT activity in 1991; and its chosen long-term provider is
also Supplier X (as in Case 1), although the client firm headquarters (and the
central relationships) are on opposite sides of the Atlantic. One of the relevant
differences is that Client C had a strategic rather than financial rationale for out-
sourcing IT. Foreseeing a period of major uncertainty in its markets at the end of
the Cold War, Client C wanted to increase its agility by de-coupling IT operations
from a particular business configuration. This did not signal a belief that IT was
unimportant to the business; in fact, retained IT managers report at more senior
Group and Division levels in Client C than they do in either Client A or B. More-
over, although they continue to employ fewer of their own IT staff than Client
A, it is markedly more than in Client B. A further contrast with the first two
cases is that Client C models its relationship with Supplier X on the wider orga-
nizational norms of the business: an enabling umbrella contract with Supplier X
is held by the Group CIO; and business divisions have their traditional obligation
to pay attention to the center’s lead, but the right not to follow it. In practice, all
divisions do use Supplier X, but through specific contracts that each has negoti-
ated for itself. Overall, Supplier X achieves annual revenues of roughly $220
million from Client C, and the relationship seems to have avoided the crises
described in the previous cases. Although we examined the overall relationship
between Client C and Supplier X, our primary focus for this case study was
Client C’s submarine manufacturing division in the northeastern U.S.
Case 4
Our fourth case study is rather different. Client D is one of the major
pharmaceutical firms, with annual revenues in excess of $18 billion. It is an
extensive user of IT and retains 2500 IT staff—choosing to outsource only IT
infrastructure (excluding software development). Until 2000, it had taken no
major IT outsourcing initiatives within an overall IT infrastructure budget of
approximately $160 million. Its decision in 2000 to outsource its IT infrastruc-
ture was driven by a desire to improve the quality and integrity of a fragmented
asset base (partly inherited through merger activity) and by a perception that
this could best be achieved through an expert external firm while internal
resources focused on development of innovation-oriented applications. The cho-
sen provider was Supplier Z, one of the large IT sector firms that have increas-
ingly diversified from hardware and software products into the provision of IT
services during the past decade. As a product provider, Supplier Z was already
well known to Client D. Both sides emphasized a spirit of partnership and a code
of behavior to support the new relationship, and a carefully structured contract
protected Supplier Z from early short-term cost pressures. At the time of the
research, this comparatively younger relationship was encountering issues but
had avoided any major crises.
The Innovation Quest

What all four case studies have in common is that they were seeking
innovation—broadly defined as improved business outcomes for the client
firm—through changes in which the supplier firm would be a principle actor. In
Case 4 the domain of change for the supplier firm was clearly bounded; in the
other three cases the supplier firm had much broader scope within which to
propose and pursue change.
Research interviews soon identified that, while innovation was the com-
mon rhetoric and quest, there was wide variation in views as to what qualified.
Supplier representatives frequently suggested examples of new technology capa-
bilities as innovation, while client executives were more concerned with busi-
ness process change or the introduction of new services. Within each case study,
we identified a number of specific innovation initiatives to be researched in
detail with those involved, and we classified them within the taxonomy depicted
in Figure 1 (to which all participants could readily relate).
Overall we positioned innovation as the introduction of strategies, busi-
ness processes, or technologies that are new to the relationship and are intended
and expected to lead to new business outcomes. Such development initiatives
did not necessarily have to be new to the entire world, only to the environment
under study. Within the model:
▪ IT Operational innovations were defined as developments that involve
technology changes not impacting firm-specific business processes. These
might include new operating systems, new e-mail platforms, or hardware
such as printing and imaging devices. Clearly such innovations were
unlikely to directly produce FIGURE 1. Categories of Innovation

new business outcomes, but
they qualified if pursued
with the expectation that
they enabled new and
superior ways of exploiting Strategic
IT, which would in turn
enable business improve-
ments to be achieved. Business Process
▪ Business Process innovations,
by contrast, do change the
way the business operates
IT Operational
in some important ways.
Innovations in this area
may include introduction of
new technologies such as
RFID devices or enterprise
resource planning (ERP) software, but only if deployed in a way that fun-
damentally alters the working processes of the organization.
▪ Strategic innovations were defined as those that significantly enhance the
firm’s product/service offerings for existing target customers, or enable
the firm to enter new markets.
The definitions thus reflect a client rather than supplier orientation (for
example, a new help desk structure might be considered a business process inno-
vation by an IT supplier, but it would be considered as at best an IT operational
innovation by most outsourcing customers and categorized as such in our work).
Apart from more general investigation of innovation objectives and expe-
rience in each case, we studied in more detail the stories of nine specific exam-
ples of innovation efforts. Our interests in each were to understand client and
supplier involvement in the origins of the idea and how it was evaluated; in the
way pursuit of the initiative was planned and developed; in implementation
action; and in evaluation of outcomes and supportive evidence.
▪ Case 1 provided four of the examples of innovation initiatives. Two were
classified as IT operational changes, each offering substantive new capabili-
ties and both successfully implemented. One initiative was in the business
process category, and was also implemented successfully. The fourth initia-
tive was a significant attempt at a strategic innovation, but it was not
achieved.
▪ Case 2 included two initiatives. While both were in the IT operational cate-
gory, they each required very substantial financial and human resources.
One was successful and did indeed enable managers in Client B to subse-
quently achieve new levels of business operational performance. The
other initiative was not successful.
▪ Case 3 represented the richest ground for innovation study, with almost
one hundred innovation projects—large and small—being pursued under
the auspices of a joint Client C/ Supplier X Review Board. We focused the
research in this case on the innovation process as a whole, but with par-
ticular attention to a successful innovation in the strategic category.
▪ Case 4, by contrast, was looking only for IT operational-level innovations
within its outsourcing relationship. We studied two initiatives in this cate-
gory, one of them having achieved success while the other was in the
process of addressing significant difficulties.
Innovations can indeed be achieved within an IT outsourcing relation-
ship, but (not surprisingly) most of the examples we found were at the IT opera-
tional level. Even at this level, failures seemed to be explained more by the IT
outsourcing context than by mistaken goals or lack of professional implementa-
tion effort. The relative scarcity of the higher-level innovation outcomes of par-
ticular interest to our client interviewees further underlines the importance of
understanding the particular challenges that an IT outsourcing context may pre-
sent. Since that context clearly varies over “time and tide,” our analysis starts
with insights to be gained from a life-cycle perspective on IT outsourcing rela-
tionships.
The IT Outsourcing Learning Curve

Why is it so difficult to achieve innovation within outsourcing relation-
ships? Clearly, effective partnerships and the innovation they may produce do
not develop overnight. Our case study research companies broadly traced the
three-stage learning journey described elsewhere by Rottman and Lacity, which
is characterized by successive focuses on cost, quality, and the new business
value that innovation can provide.6 Furthermore, it became clear that decisions
made during the first two stages can have unintended implications for success
chances in the third. To illustrate, Table 1 provides an adaptation of Rottman and
Lacity’s original model from which we can draw relevant highlights from our
case studies. While we are clear that innovation performance is driven by certain
enablers rather than by evolution, the presence or absence of those enablers
may be explained by the way client and supplier firms have reacted to earlier,
“pre-innovation” challenges.
The Cost Focus Stage

In many longstanding relationships (including our first two case studies),
IT outsourcing started with a perception at the top corporate executive level that
the IT function and activity represented a “non-core” part of their business, a
“commodity” whose cost should be minimized by external firms who were spe-
cialists in IT.7 Contracts were awarded on that basis and sponsoring executives
were gratified by the evidence from competitive bids that their IT costs could
indeed be reduced by 20% or more.8 For future innovation purposes, the poten-
tial dangers encountered in this stage are fourfold:
TABLE 1. Characteristics of the IT Outsourcing Learning Curve
Cost Focus Quality Focus Innovation Focus
Client Concerns IT as Commodity IT Underpins Business IT is Potential Enabler

Critical Activity of New Business Value
Supplier Concerns Contract Profitability Platform Development Partnership Development
Relationship Focus Constant Negotiation Best Practice IT Exploration/Ideas
Target Outcomes Cheaper IT Better IT Better Business
▪ Most (sometimes virtually all) of the employees who represent the tech-
nology know-how of the client firm are transferred to the supplier, whose
business it now is to understand IT. This has ongoing implications for the
levels of dialogue in which the client and supplier can engage and, conse-
quently, for the levels of trust.
▪ The devolution of strategic business unit IT-related decision making,
which has typically been a feature of multi-business firms, is now sharply
reversed as power comes to reside at the corporate center with the execu-
tive who owns the central contract with the supplier. This limits the free-
dom to maneuver within business units and reduces their inclination to
invest in innovations that require a significant IT component.
▪ A clear signal is given to SBU executives that IT is positioned as non-
core/commodity, and that it is not therefore expected to feature signifi-
cantly in their key business decisions. This reduces the chances that IT
managers within business units will have the involvement and influence
required to engage in innovations beyond the IT operational level.
▪ The winning supplier firm now faces the challenge of achieving contract
profitability despite an unremitting client pressure on cost and an inheri-
tance that often included outdated technology and inappropriate staffing
levels. The client-supplier relationship becomes dominated by constant
negotiation around the contract and what it included in terms of scope
and agreed pricing. A zero-sum game is played out, with suppliers poten-
tially experiencing the “Winner’s Curse,” which results when the price
required to win a contract is so low that the successful bidder cannot pos-
sibly make a profit.9 Such a low-trust buyer-supplier relationship is far
removed from the ecology required for innovation.
In our cases, Client B experienced all four of these negative effects and
Client A all except the first. The longer-term consequences can be seen in both
cases. The more strategic approach to IT outsourcing of Client C, however, pro-
tected it from all four dangers; and Client D with its focused entry into IT out-
sourcing sought to circumvent this stage altogether.
The Quality Focus Stage

Usually a number of factors combine to drive a second-stage redefinition
of the relationship, of which the two most important are a shared dissatisfaction
with the first stage and a growing realization in the wider firm that some of the
IT activity is underpinning what are business critical activities. The emphasis
now moves to ideas such as “fitness for purpose” (the “right” level of service
quality) and, while cost is still important, the metric is “value for money” with
client firms accepting that it is in their own interests to reward supplier compe-
tence with “fair” returns. The 1996 contract renegotiation between Client A and
Supplier X and that between Client B and Supplier Y in 2000 mark their con-
scious decisions to move to this stage; and the quality-before-costs terms of
Client D’s contract with Supplier Z are aligned with the intention to make a
Stage 2 entry. While the drivers of Stage 1 are antithetical to innovation aspira-
tions, the objectives of the Quality Focus Stage promote a number of develop-
ments that were helpful to our case study firms’ subsequent aspirations for
innovation, as well as their successful navigation of Stage 2:
▪ A quality objective requires both client IT and supplier managers to re-
invest in business orientation in order to understand what fitness for pur-
pose looks like. When this is combined with the goodwill generated by
service quality improvements, it can substantially improve business side
confidence in their internal and external IT providers, and it can
strengthen business/IT relationships.
▪ Client firms are prompted to take a harder look at the IT capabilities they
should retain, how their own IT staff can build a convincing understand-
ing of the business’s IT needs and then complement rather than duplicate
the efforts of the supplier in meeting them.
▪ With increased confidence in the future of the relationship, the supplier
can reconsider investment for the future. What platform will be required
to deliver the service quality, consistency, and robustness over time? How
can it be financed and achieved? Client D accepted that its IT unit costs
would actually increase significantly over several years as Supplier Z built
the new infrastructure seen as appropriate to meet rigorous regulatory
requirements in its various global pharmaceutical markets.
▪ This example points to what is now a critical discussion within the rela-
tionship: what defines “good” supplier performance, and what is a “fair”
reward for achieving it? Answering this question requires moving beyond
the contract to understand what constitutes “current best practice” in the
IT outsourcing marketplace—especially for the client firm. External
benchmark data becomes central to discussion between the parties; with
trust established by decisions that are seen to be grounded in that data.
By 2000, Client A/Supplier X and Client C/Supplier X were seen to have
achieved the objectives of Stage 2 with mutual confidence in the quality of ser-
vice provided and the cost levels at which it was being achieved. In Case 2, the
Client B/Supplier Y relationship struggled to achieve the Stage 2 objectives and
they were regularly in danger of regressing to an adversarial focus on cost. Nev-
ertheless, the examples in Case 1 and Case 3 show that important innovations at
the IT operational level can be achieved during this stage. Business process- and
strategic-level innovations require further capability.
The Innovation Focus Stage

A general weakness of life-cycle models is that they suggest an orderly
and sequential progress through a series of stages. Real life is, of course, more
complex, and we have already seen that in Case 2 the client-supplier relation-
ship oscillated between stages. In a further example, Client A and Supplier X in
Case 1 became confident by 2000 that they were ready for a new focus on inno-
vation; only to find that changes in the wider business context required them to
revisit the issues of earlier stages.
Our work takes a long view of the IT outsourcing life cycle. The model is
additive rather than sequential, with progress in any stage taking place in paral-
lel with sustained attention to the requirements of previous stages. Our frame-
work examines the requirements—rather than the aspirations—of a “final” stage
focused on added business value through innovation. Overall, our research iden-
tified nine key enablers of innovation, covering aspects of client capability, sup-
plier capability, and relationship readiness.
Understanding the Key Enablers of Innovation

in Outsourcing Relationships
Our research started with a study of previous literature on outsourcing
and inter-organizational relationships.10 While the learning curve model pro-
vided interesting insights, the many phenomena that emerged during the course
of the research required additional framing to better explain the processes and
outcomes we observed. Our case studies highlighted a subset of the existing
literature’s relationship factors as having a significant bearing on innovation
outcomes, together with some additional factors extant in other threads of the
larger body of work on innovation. Figure 2 shows the full set of identified
enablers, separated into client, supplier, and relationship enablers.
The Client Enablers

Technology Knowledge
Academics who have researched the challenge of innovation with exter-
nal partners have identified the importance of having a common base of “prior
related knowledge” between the partners, the bridging knowledge necessary for
the transfer of ideas. This concept is called “absorptive capacity” by Cohen and
Levinthal.11 For our purposes, this absorptive capacity translates into the impor-
tance of an excellent technology knowledge base within the IT function of the
client and requires the employment of a number of highly skilled technology
experts who disseminate their understandings through the wider organization in
the unique organizational context of the client.
FIGURE 2. Achieving Innovation in an IT Outsourcing Relationship
Relationship Enablers
• Innovation Governance
• Trust
• Measurement Specificity
Strategic
Business Process
IT Operational
INNOVATION OUTCOMES
Client Enablers
• Technology Skills IT Supplier Enablers
• Selective Sourcing Mindset • Business Process Skills
• IT Organizational Alignment • Industry Scope
• IT Leadership
Companies that had been through a Stage 1 outsourcing experience had

generally not catered for this requirement, concentrating their retained IT on
responsibilities related to managing the suppliers and communicating with the
business. These companies were rebuilding their in-house IT expertise during
Stage 2, albeit for the different purpose of creating effective dialogue with their
supplier in pursuit of high-quality service. Client B had downsized its pool so
dramatically that the firm felt that it could no longer effectively communicate
with its supplier. The Director of E-commerce for Client B commented:
“We’re pretty un-intelligent as customers. And I think that’s one of our weak-
nesses. We’ve got to think about, have we got the boundary in the right place?”
Client A was also struggling with the right balance of technical versus business
process knowledge. A divisional CIO for Client A said:
“I don’t need technicians; I need business people. I’ve got technicians. There’s a
role for both. I need to blend the technical expertise of Supplier X with the busi-
ness requirement of [our firm]. I need to have enough knowledge in the people I
have, so just from a technical standpoint, we know we’re not getting sold a bill of
goods.”
On the other hand, Client D never reduced its technical skills pool. The
firm maintained a large technical contingent for software development; how-
ever, these technical personnel frequently encroached upon Supplier Z’s terri-
tory in hardware and services. The supplier felt that Client D was stifling the
potential creativity of Supplier Z by over-specifying needs and micro-managing.
The “Goldilocks Principle” applies it seems—too many is no better than too few.
Client C seemed to achieve the best balance of technical and business
knowledge, but this was due to the maturity of the relationship and a conscious
decision to develop certain competencies. The divisional CIO for the submarine
division points out:
“The relationship has evolved, and we have some new people in here. We had to
do some resetting of expectations along the line here. In addition to skills in their
respective [technical] fields, whether that is application development or infra-
structure, the knowledge of the business is key for me.”
Selective Sourcing Mindset

When selective sourcing was first discussed, it referred to the strategy of
seeking best of breed IT suppliers for each distinct IT area of activity. Firms such
as BP pioneered this approach in the mid-1990s.12 Our findings expand this idea
to the concept of a selective sourcing mindset rather than a specific use of multi-
ple suppliers. In fact, all of our case studies used a single supplier for their out-
sourcing relationship. A selective sourcing mindset recognizes that IT is a
portfolio of activities and a firm should not have a homogenous structure that
constrains all aspects of its IT outsourcing relationship. Not only do various IT
activities require different treatment within the relationship, different business
units within the firm may have distinctive definitions of success as well as
widely varying acceptance criteria for deeming a technology initiative “fit for
purpose.”
A good example is the approach taken by Client C. This diversified firm
has business units ranging from a builder of submarines to a corporate jet manu-
facturer. Client C has a preferred supplier, but its business units are free to nego-
tiate their own contracts. The Client C CIO (now retired), described the mindset:
“Whereas with many other companies the deal is done at the corporate level and
everybody has to live with it, we have an umbrella agreement that has general
terms and conditions. Each business unit is under that umbrella. But when they
outsource, they do their own deal. I don’t negotiate a deal for them. I introduce
the parties and I act as referee to make sure the deal is fair.”
Two of the other case studies also demonstrated a willingness to consider

multiple approaches to sourcing IT. Client D retained a large in-sourced opera-
tion for software application development and Client A was exploring a selective
sourcing arrangement for its upcoming contract renewal. Only Client B seemed
inextricably wedded to its IT supplier, and this was despite significant relational
turmoil. While the poor results at Client B could not be explained solely by a
lack of a selective sourcing mindset, certainly the inability to consider alternative
sourcing arrangements contributed to the stagnant relational environment.
While the use of multiple suppliers may promote innovation through
access to a wider set of ideas, the selective sourcing mindset is the real key. The
importance of this enabler emerges in a Stage 2 relationship as the mindset

allows client and supplier to recognize a range of solutions as “fit for purpose.”
When the attention of the firm shifts to business-level innovations and their
distinctive characteristics, this mindset becomes essential.
A Match between Client IT and Corporate Structure

Alignment between IT and the business organization in a “federal” model
has long been accepted wisdom.13 A federal IT organization provides the oppor-
tunity to agree on centralization of IT activities that benefit from scale
economies, alongside the flexibility to respond to needs of business units across
the firm (as demonstrated in Case 3). As noted, this alignment was frequently
broken at the start of outsourcing relationships by the effective centralization of
IT through a contract that was corporately inspired and managed. This situation
occurred in Case 2. The firm was multi-divisional and federal, but the outsourc-
ing agreement was managed centrally.
To achieve innovation outcomes that go beyond the IT operational, align-
ment needs to be rebuilt. If business leaders are to take the risks implied by busi-
ness process- and strategic-level innovations, it is understandable that they want
the IT components of those innovations directed by IT staff whose understand-
ing of and loyalty to their business agendas is clear.
Executive-Level IT Leadership
Strongly related to the need for IT organizational alignment is executive-
level leadership of IT. Whatever the formal nomenclature (CIO, IT Director), the
term refers to an IT leader who sits one or two levels below the business CEO in
the organizational structure, who has regular access to the CEO and other key
players, and who is regarded by them as an important member of the business
team. Again, this is not a new idea in the context of exploiting IT for business
value,14 but it is an idea that often needs to be re-examined within the context
of outsourced IT.
The direct need is to establish or re-establish excellent relationships
between CEOs and IT Leaders within the business units where innovation initia-
tives are being promoted. However, we found that firms struggled to get this
enabler in place at business unit level if a different situation exists at corporate
level. As one frustrated IT executive at business unit level for Client B explained
to us:
“Our Corporate CIO is five layers down in the organization. And this is a part of
the problem—our company does not have, in my view, at the enterprise level, the
vision of what IT means to their business. They don’t understand it to the extent
they’re willing to change their organization structure and their operating model to
reflect IT’s importance to the firm.”
Having executive-level IT leadership at the corporate level both signals

the desirability of having it at the business unit level and provides an informed
and supportive review capability for innovation proposals. Executive-level IT
leadership is required at both corporate and business unit levels of the client
firm, and one cannot sustainably exist without the other.
The IT Supplier Enablers

As we now discuss innovation enablers required in the supplier, we take
for granted some “basics.” Specifically, we assume that the supplier possesses the
technical and management skills required to convincingly deliver whatever are
the existing services under contract. They may well in addition have
implemented innovations at the IT operational level. Our concern here is to
describe the additional capabilities required to help the client achieve higher-
level innovation outcomes.
Business Process Design Knowledge

Business process design knowledge represents the “prior related knowl-
edge” (the absorptive capacity) required in a supplier who can partner in the
pursuit of higher-level innovation outcomes. It is the mirror image of the client-
side requirement for retention of “technical knowledge.” In a relationship that
originated with a Stage 1 cost focus, the supplier may well have inherited some
knowledge of client business processes through the transfer of some of the
client’s IT staff. However, this knowledge may have atrophied during a period of
cost reduction, and in any case does not imply the design knowledge compo-
nent. The requirement is for the supplier to develop extensive knowledge of
client business processes and to be able to contribute to discussions and subse-
quent action plans targeted at their improvement. This represents a conscious
up-front investment of resources by the supplier, but one that may be easier to
make if the client and supplier are working together in “fair returns” mode
within the longer-term perspective of a Stage 2 period of quality focus.
Client-Industry Scope of the Supplier

The depth and breadth of the supplier firm’s relationships with other
client firms and industries is a determinant of what external knowledge they
may bring to innovation initiatives. Suppliers with depth (multiple relationships)
in a client’s industry may have previously encountered specific challenges that
the client faces. Suppliers with exposure to clients in a wider variety of indus-
tries are assumed to be able to deliver radical ideas from these disparate sources.
The clients in our study tended to benefit more from suppliers with industry
depth, rather than industry breadth. For example, a significant innovation at the
business process level involved the transfer of submarine manufacturing control
processes from Client C to Client A. The IT supplier had two clients in this indus-
try, Client A and Client C. The British firm adopted the control process devised
by the American firm at the prompting of the IT supplier and a divisional CIO
for Client A, who demonstrated the business process knowledge required to
implement the advanced systems on which the new processes were based.
While we did not encounter significant innovations that used the breadth
of a supplier’s client base to the benefit of our research participants, this is not
unexpected as it represents higher levels of challenge and risk. Nevertheless, as

firms grow their experience and confidence in innovation within relationships,
some “cross industry” examples of transfer may be expected in future.
The Relationship Enablers

The final element in our model identifies the way in which the client-
supplier relationship must grow to achieve innovation outcomes. We identified
three enablers in this element. Two of them—trust and measurement
specificity—will probably have been developed in a Stage 2 context. The third—
innovation governance—is very specific to the Stage 3 focus on innovation and
the creation of new business value.
High Levels of Trust

Trust within an outsourcing relationship is a factor at work even before
the outsourcing contract is signed. One might expect that the typical negotiation
process would be harmful to trust, but previous research, as well as our study,
found that firms are likely to start a relationship with high levels of trust since
they have mutually concluded a successful contract negotiation phase.15
To understand the complexities of the trust environment, we reviewed
models of trust in a wide range of contexts.16 We developed a three-pronged
model of trust that reflected the complexities of the outsourcing environment:
personal trust, competence-based trust, and motivational trust. These elements
illuminate the fundamental tensions in even the best outsourcing relationships.
▪ Personal trust refers to the confidence one has that another person will
work for the good of the relationship based on their integrity and adher-
ence to moral norms. Cross-cultural relationships can complicate one’s
understanding of “moral norms,” but generally researchers have found
that people are surprisingly willing to trust one another until that trust
has been violated.17 The uncertainty inherent in innovation efforts adds
another element to personal trust. Namely, when things go wrong, who
will suffer the consequences? In relationships with high personal trust
there is an understanding that all parties will accept responsibility for risks
that do not work out, rather than “pointing fingers” or deflecting blame.
▪ Competence-based trust exists when one party has confidence that the other
will successfully deliver their allocated tasks and responsibilities. Success-
ful completion of projects and achievement of joint goals will enhance
competence-based trust, while operational failures will degrade it. The
fact that a supplier wins the initial negotiations surrounding the outsourc-
ing contract typically creates goodwill for the very early phases of the
relationship. However, when operational problems are encountered (the
norm in Stage 1), the competence-based trust starts to erode. As relation-
ships move into Stage 2, the focus on quality provides the opportunity to
improve this type of trust. In a Stage 3 focus on innovation, high levels of
competence-base trust are required between business leaders and their
“executive-level IT leaders,” as well as between client and IT supplier

teams.
▪ Motivational trust refers to the idea that both parties believe the rewards
and punishments they experience are geared towards achievement of
joint goals, a Win/Win situation. Bonus structures and risk-sharing mech-
anisms are elements that can be used to build this type of trust for the
relationship. These are unlikely to have featured in the initial arrange-
ments of a long-standing arrangement, but can be implemented subse-
quently within a selective sourcing mindset. They are the Stage 3
equivalent of the “fair return” approach of Stage 2.
We observed synergies arising across the trust model when innovation
activities were successfully completed, a simultaneous reinforcement of all three
forms of trust. Client C had achieved this rosy environment after a number of
years of mutually beneficial projects with its supplier. Conversely, Case 2
demonstrated a situation in which a series of failures created a “death spiral”
environment in which all three forms of trust were degraded and neither party
had sufficient trust in the other to move forward. The lack of technology invest-
ment around the year 2000 at Client B created problems implementing innova-
tive technologies and these failures harmed competence and personal trust. The
lack of trust also made modifying the motivational trust framework difficult and
little progress was made in the relationship until the Supplier Y management
team was replaced. The new team used small efforts to create personal trust and
build a foundation for future growth.
High Levels of Measurement Specificity

Measurement specificity refers to the level of detail at which activity is
monitored, as prescribed in the outsourcing contract and any supplementary
arrangements. Measurement is a critical success factor in the relationships we
studied, with one senior executive for Client B capturing the sentiment in her
comments:
“When people are prepared to put a lot more effort into specifying what they
want, I think they get a much better product.”
Conventional wisdom suggests that a relationship with high levels of trust

does not require high levels of measurement specificity. After all, if the two par-
ties truly trust each other, there is no need to detail every contingency in a con-
tract. While the level of contract detail did differ among relationships in our
research, the stronger relationships maintained a tight reign over service levels
and costs (as in Case 3). These measurement mechanisms achieved two positive
outcomes. First, the detailed attention to service levels gave the firms a clear idea
where to target innovation efforts; and second, the firms were able to monitor
costs and benefits of innovation activities more effectively. The “trust but verify”
approach demonstrates to both parties that the trust in each other was well
placed, with a correlation between investment in measurement specificity and
achievement of higher levels of innovation.
Effective Innovation Governance

Innovation within outsourcing relationships brings its own specific gover-
nance challenges at three levels: what ideas should be selected for investment;
what processes should be used to manage implementation; and how should each
party be rewarded for success. In our research, we were surprised to find that—
despite a formal recognition of an innovation objective—these issues were some-
times addressed in an ad-hoc fashion, with each innovation opportunity being
addressed individually. By contrast, effective innovation governance arrange-
ments build confidence within the relationship that innovation efforts will be
handled in a consistent and transparent way.
Within these parameters, effective arrangements could take different spe-
cific forms, one requirement being that they were aligned with related processes
of the client firm, or a particular business unit within it. The most convincing
arrangements had the following features:
▪ An innovation board jointly populated by client and supplier executives.
The board met quarterly to review and select new initiatives from the
ideas put forward from either side of the relationship and met monthly to
review the progress of initiatives already sanctioned.
▪ When selecting new initiatives, the board considered the economic argu-
ments provided by champions of new ideas and the financial capacity for
pursuing them within an agreed annual budget for innovation. However,
it also considered whether it had the management capacity available for
implementation. Every selected idea required an allocated project man-
ager as well as a champion, to ensure that implementation was subject to
formal project disciplines. The board “owned” the available pool of project
managers, whose numbers were limited by consideration of how much
change could be handled in parallel, as well as by the total budget avail-
able.
▪ Since the champions of innovative ideas are inevitably reluctant to give
up on them, progress reviews gave particular weight to the views of the
more dispassionate project manager when deciding to continue with
implementation of innovation initiatives.
▪ It was recognized that ideas of “benefit sharing” were difficult to imple-
ment in these relationships since the target outcome for the client might
be hard to evaluate in quantitative rather than qualitative terms. In the
most productive of the partnerships we studied, the supplier’s incentive to
participate was that it could achieve, through the innovation budget,
additional revenues of several million dollars.
Whatever specific form they took, effective innovation governance
arrangements were critical to the establishment of “motivational” trust within
the relationship.
FIGURE 3. The Enablers of Innovation for Outsourcing Relationships
All Three Types of Trust

Strategic
Executive Level IT Leadership
Measurement Specificity
Selective Sourcing Mindset
Effective Innovation Governance
Trust
Business Process
Client-Industry Scope of Supplier
Client IT and Corporate Structure Match
Supplier Business Process Design Knowledge
IT Operational
Client Team
Technology Knowledge Personal Trust
A Composite Model of Innovation

in IT Outsourcing Relationships
Reflecting the pyramid shape of Figure 1, our research encountered many
examples of IT operational innovations; a growing aspiration for achievement of
business process-level innovations, with several convincing examples of success;
and relatively few examples of strategic-level innovations. A holistic view of the
research suggests the composite model of innovation enablers displayed in Fig-
ure 3, where pursuit of innovation within IT outsourcing relationships follows
an evolutionary learning model.
The model positions just two of the enablers as necessary to the achieve-
ment of IT operational innovations. First the client must have in place the techni-
cal knowledge that allows rich discussion of ideas at this level to be confidently
pursued with the supplier. Secondly, there must be personal trust across the
relationship. In our least successful case study (Case 2), a lack of personal trust
compromised the ability to accomplish even the most modest innovation efforts
at the IT operational level.
Success at the business process level of innovation requires that several
additional building blocks are in place: the availability of business process design
skills within the supplier, together with establishment of competence-based trust
and access to substantive depth of knowledge of the client’s industry; alignment

within the client of IT and business organization; and a selective sourcing mind-
set, accompanied by effective innovation governance. The development of
process data management for Client A provides a good example. The supplier
(Supplier X) had established a good track record of supporting the relevant
process at one of its other clients within the defense industry. At the instigation
of the UK business head, they agreed to transfer the relevant skills and knowl-
edge. The business head and his supporting IT function were able to devise
sourcing arrangements and innovation governance that were appropriate to this
specific requirement. Over a six-month period, the business process was success-
fully re-engineered and supported by new IT systems.
The biggest threat to success was the lack of executive-level IT leadership
at either corporate or business unit levels of the client. Fortunately, the client’s
business unit head had significant personal experience in IT and he was both
able and motivated to provide the necessary leadership. By contrast, in our
example of a strategic innovation, executive-level IT leadership was well estab-
lished at both the corporate level in Client C and in its submarine subsidiary. As
the build-out for a long-running contract for submarines neared completion,
Client C’s strategic direction was to move into marine overhaul—a market in
which they had no recent presence. One project manager explained:
“The last time we did overhaul I don’t think there were computers. So how do we
make our systems work for this type of business? How do we quickly move our IT
infrastructure to these new sites?”
The CIO for the submarine division at Client C took the initiative to
involve Supplier X in early and high-level discussions about the implications of
the new direction. Elsewhere within the firm, Supplier X had the relevant
expertise, and during a long-established relationship Supplier X had developed
the motivational trust with Client C that gave them the confidence to respond.
The joint project expanded the Client C environment into new locations, new
markets, and a new product. Client C’s successful transition into the overhaul
market was highlighted in Client C’s 2006 annual report.
Revisiting the Learning Curve with Innovation in Mind

It is the enablers, not a broader learning journey, that drives innovation
performance. Some of the enablers identified (e.g., client technology skills and
measurement specificity) are highly relevant to the achievement of quality as
well as innovation outcomes. Other enablers are more specific to innovation,
and putting them in place may present some challenge to the arrangements
established in pursuit of cost and/or quality objectives. Importantly, the learning
curve is a descriptive rather than prescriptive model. Case 4 provides an example
of a company with hitherto in-sourced IT essentially bypassing two stages and
“jumping in” to achieve innovation objectives. If innovation is the objective, the
enablers point to the agenda for action—but reference to positioning on the
learning curve may provide additional insight into the challenge of putting the
enablers in place.
Some Conclusions for Innovation

within IT Outsourcing Relationships
Until recently, few, if any, major IT outsourcing decisions were triggered
by a desire to use IT as an enabler of innovation. However, many organizations
have now been outsourcing most of their IT activity for a decade or more, and
they are now making innovation a key future requirement for their relation-
ships. While innovation can indeed be achieved within outsourcing, it is depen-
dent on certain attributes within client and supplier, and in the relationship
between them. On the client side, the attributes identified would be needed
within a value-adding IT function that was not outsourced: excellent technical
knowledge, alignment with the business, executive-level leadership, and an
approach that recognizes IT as a portfolio of activities with distinctive manage-
ment needs. The supplier must be prepared to invest in business process design
skills beyond its IT core, and the supplier can bring added innovation potential if
it has in-depth involvement in the industry sector(s) of its client. Apart from
developing the style of governance that would be required to support innovation
in any context, the key new requirement of the client/supplier relationship is
that it should develop the levels of trust that are more easily achieved within a
single organization.
APPENDIX
About the Research
The concepts presented here are the result of a two-year study of the
effects of IT outsourcing relationships on business innovation. The research
included four primary case studies, featuring three “client” firms in
aerospace/defense and one in the pharmaceutical industry. All were interna-
tional firms with multi-billion dollar revenues and perceived to be leaders in
their sectors. Their IT outsourcing relationships, mostly of long standing, were
with three of the most prominent providers of such services. More than 70
detailed interviews were conducted with client and supplier representatives in
roughly equal measure. Interviews included client CIOs at the corporate and the
business unit levels, and the most senior account executives within the suppli-
ers. Interviewees were asked to share their perceptions of all important aspects
of the outsourcing context and relationship and to describe examples of both
successful and unsuccessful innovation initiatives, with their own insights into
what had an impact on these outcomes. After transcription and analysis, our
findings were presented back to research participants for discussion and
validation.
Notes
1. P.F. Drucker, “The Discipline of Innovation,” Harvard Business Review, 76/6
(November/December 1998): 149-157; A.H. Van de Ven, D.E. Polley, R. Garud, and S.
Venkataraman, The Innovation Journey (New York, NY: Oxford University Press, 1999); H.W.
Chesbrough and D.J. Teece, “Organizing for Innovation,” Harvard Business Review, 80/8
(August 2002): 27-135.
2. M.J. Earl and D.F. Feeny, “Is Your CIO Adding Value,” Sloan Management Review, 35/3
(Spring 1994): 11-20; K. Yamada, “The Innovation Imperative,” CIO Insight, (October 2001),
pp. 35-42; M. Polansky, T. Inuganti, and S. Wiggins, “The 21st Century CIO,” Business Strat-
egy Review, 15/2 (Summer 2004): 29-33.
3. Y. Shi, “Today’s Solution and Tomorrow’s Problem: The Business Process Outsourcing Risk
Management Puzzle,” California Management Review, 49/3 (Spring 2007): 27-44.
4. M.C. Lacity and R. Hirschheim, “The Information Systems Outsourcing Bandwagon,” Sloan
Management Review, 35/1 (Fall 1993): 73-86.
5. H. Chesbrough, Open Innovation (Boston, MA: Harvard Business School Press, 2003); C.M.
Christensen and M.E. Raynor, The Innovator’s Solution (Boston, MA: Harvard Business School
Press, 2003); D.J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabilities and Strategic Man-
agement,” Strategic Management Journal, 18/7 (August 1997): 509-533; Ven, Polley, Garud,
and Venkataraman, op. cit.
6. J.W. Rottman and M.C. Lacity, “Proven Practices for Effectively Offshoring IT Work,” MIT
Sloan Management Review, 47/3 (Spring 2006): 56-63.
7. C.K. Prahalad and G. Hamel, “The Core Competence of the Corporation,” Harvard Business
Review, 68/3 (May/June 1990): 79-91.
8. Lacity and Hirschheim, op. cit.
9. T. Kern, L.P. Willcocks, and E. van Heck, “The Winner’s Curse in IT Outsourcing: Strategies
for Avoiding Relational Trauma,” California Management Review, 44/2 (Winter 2002): 47-69.
10. T. Kern, “Relationships in Information Technology Outsourcing: An Exploratory Research
Study of a Conceptual Framework,” D.Phil. diss., Christ Church College, University of
Oxford, 1999; I.R. Macneill, The New Social Contract: An Inquiry into Modern Contractual Rela-
tions (New Haven, CT: Yale University Press, 1980).
11. W.M. Cohen and D.A. Levinthal, “Absorptive Capacity: A New Perspective on Learning and
Innovation,” Administrative Science Quarterly, 35/1 (March 1990): 128-152.
12. J. Cross, “IT Outsourcing: British Petroleum’s Competitive Approach,” Harvard Business
Review, 73/3 (May/June 1995): 94-102; J. Cross, M.J. Earl, and J.L. Sampler, “Transforma-
tion of the IT Function at British Petroleum,” MIS Quarterly, 21/4 (December 1997): 401-
423; M.C. Lacity, L.P. Willcocks, and D.F. Feeny, “The Value of Selective IT Sourcing,” Sloan
Management Review, 37/3 (Spring 1996): 13-25.
13. F. Rockart, M.J. Earl, and J.W. Ross, “Eight Imperatives for the New IT Organization,” Sloan
Management Review, 38/1 (Fall 1996): 43-54.
14. Earl and Feeny, op. cit.; D.F. Feeny, B.R. Edwards, and K.M. Simpson, “Understanding the
CEO/CIO Relationship,” MIS Quarterly, 16/4 (December 1992): 435-448.
15. D.H. McKnight, L.L. Cummings, and N.L. Chervany, “Initial Trust Formation in New Organi-
zational Relationships,” Academy of Management Review, 23/3 (July 1998): 473-490.
16. J.D. Lewis and A. Weigert, “Trust as a Social Reality,” Social Forces, 63/4 (June 1985): 967-
985; M. Sako, Prices, Quality and Trust: Inter-firm Relationships in Britain and Japan (Cambridge:
Cambridge University Press, 1992); O.E. Williamson, “Calculativeness, Trust, and Economic
Organization,” Journal of Law & Economics, 36/1, part 2 (April 1993): 453-486; A. Zaheer and
N. Venkatraman, “Relational Governance as an Interorganizational Strategy: An Empirical
Test of the Role of Trust in Economic Exchange,” Strategic Management Journal, 16/5 (June
1995): 373-392; L.G. Zucker, “Production of Trust: Institutional Sources of Economic Struc-
ture, 1840-1920,” in B.M. Staw and L.L. Cummings, eds., Research in Organizational Behavior,
Volume 8 (Greenwich, CT: JAI Press, 1986): 53-111.
17. McKnight, Cummings, and Chervany, op. cit.

From Cost Management To Innovation and Business Value

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From Cost Management To Innovation and Business Value

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Outsourcing:

FROM COST MANAGEMENT TO

The Scope of the Research

The Innovation Quest

unlikely to directly produce FIGURE 1. Categories of Innovation

The IT Outsourcing Learning Curve

The Cost Focus Stage

TABLE 1. Characteristics of the IT Outsourcing Learning Curve

Cost Focus Quality Focus Innovation Focus

Client Concerns IT as Commodity IT Underpins Business IT is Potential Enabler

Supplier Concerns Contract Profitability Platform Development Partnership Development

Relationship Focus Constant Negotiation Best Practice IT Exploration/Ideas

Target Outcomes Cheaper IT Better IT Better Business

The Quality Focus Stage

The Innovation Focus Stage

Understanding the Key Enablers of Innovation

The Client Enablers

FIGURE 2. Achieving Innovation in an IT Outsourcing Relationship

Companies that had been through a Stage 1 outsourcing experience had

Selective Sourcing Mindset

Two of the other case studies also demonstrated a willingness to consider

importance of this enabler emerges in a Stage 2 relationship as the mindset

A Match between Client IT and Corporate Structure

Having executive-level IT leadership at the corporate level both signals

The IT Supplier Enablers

Business Process Design Knowledge

Client-Industry Scope of the Supplier

unexpected as it represents higher levels of challenge and risk. Nevertheless, as

The Relationship Enablers

High Levels of Trust

“executive-level IT leaders,” as well as between client and IT supplier

High Levels of Measurement Specificity

Conventional wisdom suggests that a relationship with high levels of trust

Effective Innovation Governance

FIGURE 3. The Enablers of Innovation for Outsourcing Relationships

All Three Types of Trust

A Composite Model of Innovation

and access to substantive depth of knowledge of the client’s industry; alignment

Revisiting the Learning Curve with Innovation in Mind

Some Conclusions for Innovation

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