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Knowing what you need.

To pick the right kind of outsourcing arrangement, you must first understand what is driving you to consider an outside vendor.

DECIDING WHETHER OR not to outsource your operation's data processing function neither a simple nor a single decision. It may, in fact, be one of the most complex, risky and important business decisions that you make. Because it involves the evaluation of a series of related complex and distinct service offerings, it is important that you know precisely what is motivating you to consider outsourcing.

Outsourcing is a very general term that covers the management of a department or service within an organization by an outside firm. Within the mortgage banking and financial services industries, the most common forms of information systems outsourcing are:

* The provision of remote services using standard software and procedures. This arrangement is typically called a service bureau.

* The provision of services using the mortgage bank's or bank's proprietary systems or licensed software. Called facilities management, it is the on-site management of an institution's data processing environment. Typically, a facilities management firm either hires the institution's information systems staff or provides staff to support information systems at the institution's data center. In some cases, the institution maintains hardware and software licenses.

* The provision of hardware and resources at a remote site to support the institution's proprietary systems or licensed software. Called resource management, an outsourcing vendor will support the mortgage banker's or bank's software at a vendor's location. Software development may be provided by the financial institution's staff, if desired.

Determining which of these outsourcing approaches, or combination thereof, would be in your institution's best interest, is a challenging task. By understanding what you are looking for in considering a move to outsourcing, you are more likely to choose the type of arrangement and vendor that will most likely satisfy your needs.

What is your motivation?

The best way to start is to identify which of the following factors are motivating your interest in outsourcing:

* Cost reduction;

* Improved cost predictability;

* Need to update existing, outdated technology;

* Lack of current system reliability/up-time;

* Lack of internal expertise;

* Need for significantly improved system functionality;

* Need for increased information system productivity;

* History of missed deadlines;

* Need to consolidate acquired operations with existing ones;

* High staff turnover rate;

* Reduction of data processing investments in training, standards and development and reporting tools;

* Recognition of outsourcing as a trend that deserves an assessment.

By understanding your motivation, you can better make a "first cut" assessment of the likelihood that outsourcing will answer your needs. Furthermore, by recognizing the issues associated with each type of outsourcing arrangement, you can structure an evaluation process that focuses on your particular situation.

This article will explore one bank's outsourcing dilemma and the case underscores the importance of understanding the business motivation behind a decision to pursue oursourcing. A client of Deloitte & Touche, which we will refer to as "BANK," is a medium-size financial institution (assets between $500 million to $1 billion) with three- to five-year growth plans that involve acquisitions across several states.

The institution's in-house data processing environment is customized packaged software and the bank's data processing costs are extremely high, due primarily to an overstaffed and oversized data center. BANK is also facing serious computer capacity and performance issues. This translates into significant, capital expenditures for a CPU upgrade, additional disks, software upgrade license and higher ongoing hardware and software maintenance costs.

Let's first explore data processing outsourcing alternatives and then analyze BANK's motivations for pursuing an outsourcing solution. For this institution, understanding its reasons for exploring outsourcing actually leads to a tailor-made outsourcing arrangement.

Service bureau--reduced expense versus reduced systems control

While the motivation to reduce costs may be satisfied with most outsourcing arrangements, the service bureau option typically provides the greatest savings, because the vendor offers one systems environment, with associated technical support, under a long-term contract, to multiple financial institutions. One must be cautious, however, because savings can be dramatically affected by the bank through contract negotiations and the use of services that are charged on a per-item or extra-fee basis. Identifying initial savings in a service bureau environment is not difficult, but managing the long-term use of services can be. This option is particularly challenging for those institutions that are accustomed to having total control over an in-house information systems department.

Another factor to consider is the fact that price packaging varies among vendors. Price scenarios may include:

* Pricing on a per-transaction or per-account basis.

* A flat monthly charge with a per-item charge in excess of base amounts.

* A flat fee regardless of account/transaction volume.

Costs can increase dramatically over a contract term when service is priced on a per-item basis. Additional opportunities for vendors to increase customer costs include charging for supplemental products and services, reporting tools and customer change requests. Supplemental services and reporting tools are typically established as per-item charges. These services can be valuable to supporting a bank's information, customer and regulatory requirements, but the appropriate controls and procedures must be established to effectively utilize these services within the bank's budget constraints.

Software customization or change requests are other services that can be costly to the bank or mortgage banking institution. In any service bureau arrangement, the system will not satisfy all customers' requirements and requests. This "control over your environment" is limited, unless the customer is willing to bear the cost of uniqueness.

Cost predictability depends on how the contract is structured. When pricing is a flat monthly or annual base fee, the costumer achieves greater cost predictability. Some vendors price their services on usage and/or transaction/account volumes. In such cases, costs are more difficult to predict over the life of the contract. In addition, many vendors build into their contract pricing a cost-of-living adjustment (COLA). The COLA is calculated as an annual percentage increase, often with a cap or "not to exceed" clause.

Cost containment is a significant advantage for service bureau customers, but with the savings also come a long-term contract and commitment. Most vendors want a five- to seven-year commitment and impose early contract termination penalties. This contract commitment permits the outsourcing vendor to invest in a data center environment that meets its clients' long-term needs at an affordable cost (e.g., featuring long-term hardware, equipment and facility leases; permanent technical and customer service resources; and so forth.) A long-term contract favors the outsourcing vendor and offers cost advantages to customers, but some financial institutions use outsourcing as a short-term fix of immediate problems; thus, a long-term contract with early termination penalties could impose restrictions on their future business plans.

While cost containment is a significant advantage when considering outsourcing, management typically expects to improve its current systems and operations with such a move. Otherwise, the "pain" of change or conversion is not justified. Converting to a service bureau scenario can offer many technological benefits to financial institution customers. The degree to which these benefits are realized, however, is based on the bank's outsourcing motivation. If cost is the only motivation, then the chosen solution may not result in overall system improvements. But if other motivations affect the outsourcing decision, then an institution may realize some of the other benefits.

Leading service bureau providers offer current technology solutions to customers that are easier to support, maintain and respond to user and regulatory changes.

Furthermore, increased system reliability is assumed when contracting with a service bureau; otherwise, the vendor could not maintain its customer base. Typically, service level agreements and disaster recovery are included in the contract to provide a superior level of service to mortgage banking and banking customers.

Many service bureau vendors have a large and somewhat specialized staff to support not only computer operations for all customers but also a development staff to support software customization, conversion/branch acquisition assistance, equipment installation, branch automation and so forth. Improved technical expertise is a significant benefit to customers, because customers only pay for the technical resources as they are needed (e.g., when branches are acquired).

Improved system functionality may be a benefit when institutions are motivated to improve their existing information system, whether in-house or outsourced. Some financial institutions fear that converting to a service bureau will result in loss of competitive position because their systems will look like other competitors; however, this is only true if the institution's in-house system was superior from the start.

Because a service bureau solution is designed to serve many customers' needs, the system is typically designed with many user options or parameters. This allows the customer to design and implement financial products, as opposed to obtaining technical resources to "program" a new product. Secondly, vendors typically provide reporting tools to their customers to design and print their special reports. Again, technical resources are not required to "program" special report requests. This systems productivity boost is typically realized when a bank is moving away from an environment that is highly dependent on programmer resources for information.

Management is frequently frustrated with its inability to deliver systems on time and within budget and, as a result, it increasingly looks to outsourcing vendors to improve its track record of project delivery. Vendors can often succeed where individual institutions have failed because they have a larger pool of personnel who have working familiarity with the same software. However, the ultimate success of any project depends on the commitment of the institution.

Many banks or mortgage banks grow through acquisition of either entire institutions or mortgage companies, or by buying just a few branches. As a result, they are faced with incorporating these acquisitions under their existing system umbrellas. Because substantial, one-time costs to consolidate systems will be incurred anyway, why not convert to a service bureau? Service bureaus have the resources and expertise to expedite the consolidation of new systems.

Some financial institutions consider outsourcing to minimize the responsibility and cost of maintaining a data processing staff. The high cost of staff turnover is eliminated with a service bureau option. Typically, a core liaison staff is maintained at the financial institution to work directly with the vendor on systems needs. In addition, the substantial data processing investments in programming tools, methodology, standards, software aids, technology training and so forth, are also eliminated, since those investments become the outsourcing vendor's responsibility.

A second outsourcing scenario that offers many of the advantages of service bureau processing is facilities management. Although typically more expensive than a service bureau, it does provide clients with the feeling of more control over their data processing environment because the vendor is managing system development and production operations at the client's location.

Facilities management--increased systems control versus increased expense

Facilities management may be a more attractive option to a financial institution with an in-house data processing environment, because the institution still has on-site visibility and control over its data processing hardware and software. This on-site control, for some institutions, translates into a competitive advantage through personalized service and customized product offerings.

Cost savings can come from a number of different sources, but they are typically not as significant as with a service bureau solution, because the vendor is supporting only one client, your institution's data processing. The significance of cost savings depends on how the contract is structured. For example:

* Hardware ownership--Sometimes a vendor can provide equipment and/or maintenance less expensively than the individual financial institution due to volume purchases.

* Software license--If the facilities management vendor is also the software vendor, then the client does not pay for software license fees. If the facilities management vendor does not license the software currently processed at the institution, then the vendor, and ultimately the financial institution customer, may incur additional software license fees.

* Software customization--A vendor typically charges clients to support a customized version of its software, because it requires more resources to maintain a modified software environment. If the client is willing to back away from software changes, then its ongoing costs are reduced. However, a facilities management arrangement may be staffed to handle some system customization and the financial institution may not incur a per-change fee as is typically found in service bureau processing.

* Conversion--If the institution wants to continue with its current systems environment, then the bank or mortgage bank will incur minimal conversion costs. If, however, the institution is moving to a facilities management arrangement with vendor-provided software, then the institution pays the vendor to convert its data and dedicates the resources to define the new systems environment.

* Staffing--A facilities management vendor provides on-site technical expertise to its client to support data processing, generally on a long-term basis. The amount of resources required to support the desired software environment depends on a number of factors (some of which are listed below) and ultimately affects the total cost: * Vendor-owned software; * Degree of environment customization; * Short- and long-term client plans; (e.g., how quickly does the vendor need to respond to branch acquisitions?)

* Contract commitment--As in service bureau processing, the outsourcing vendor looks for a five- to seven-year relationship with its clients. The longer the contract term, the lower the cost. Should a client desire more short-term arrangements, the cost advantages may not be significant.

In addition to the items already discussed, there are other motivating factors behind a decision to opt for a facilities management approach. These motivating factors may include a desire to:

* Replace or improve outdated technology--If the client's hardware and/or software needs upgrading and/or replacement, this may be included as a service provided by the outsourcing vendor.

* Improve technological expertise--This can be a critical motivation behind a facilities management decision. If the client is unable to meet users' expectations, it may look to an outsourcing vendor to assume responsibility for hiring and managing quality technical resources.

* Improve system functionality--If the client is replacing its current environment with the outsourcing vendor's recommended software, then the client may take advantage of new capabilities. Typically, the facilities manager has an abundance of expert resources that assist clients with system installation.

* Enhance ability to deliver on time--This attribute is also a strong motivating force behind a decision to go with a facilities management approach. If the client's resources cannot deliver systems on time, then perhaps an outsourcing vendor with technical resources familiar with its software can better achieve this goal.

A third outsourcing alternative is a combination of service bureau and facilities management, called resource management. A resource management arrangement allows an institution's current environment to be processed at the vendor's location.

Resource management--remote processing of current environment

As in facilities management, contract variables can play a key role in satisfying the client's outsourcing motivations. The advantage of this scenario is that the institution no longer incurs costs for equipment, facilities, people and sometimes software license fees; however, software processed at the vendor's site may be expensive because of heavy customization, lack of documentation and so forth. In addition, contract terms may be move flexible, depending upon the availability of data centers, excess computer capacity and under-utilized resources by the vendor.

Typically, what motivates a client to decide in favor of a resource management arrangement is not software-driven, but rather people-driven (and perhaps driven by a desire to reduce costs, as well). A typical scenario is an institution that has been unsuccessful in managing its in-house technical resources and is unable to deliver quality service and satisfy user expectations. Although the users and management are happy with current software functionality, the financial institution may no longer be able to justify the costs of a separate facility, hardware and support staff for the institution's information processing environment. As a result, the institution may attempt to convert or relocate its software environment to a vendor's location for ongoing development and production operations. A bank or a mortgage bank may even choose to outsource only production operations, while maintaining some control over ongoing system development if system tailoring is critical to the institution's business strategies. Again, the degree of savings depends upon the software environment and contract terms.

As previously noted, both facilities management and resource management approaches can offer clients creative data processing alternatives that solve existing problems, improve operations and even reduce costs. However, cost advantages are determined by the degree of flexibility and control clients demand in order to meet their business needs, the quality of the institution's existing software environment and the ability of management to respond to a more structured data processing operation.

A case example: BANK's outsourcing dilemma

In this example, BANK was facing significant CPU capacity and performance problems, which meant increased hardware costs and software license fees. In addition, its present data processing costs were unusually high for a medium-sized institution. Lastly, users perceived that the customized software lacked functionality and management reporting features, but upon further investigation, it was discovered that this was due to earlier computer capacity and performance issues. Let's track the affect of these motivations on the final outsourcing decision.

A service bureau arrangement satisfies the above-mentioned motivations to resolve the computer capacity and performance problem, improve system functionality and achieve cost reduction. But senior management had two concerns:

* A new service bureau might improve current functionality, but it would also involve a conversion. BANK did not want to go through another conversion. In addition, it appeared that current system functionality was limited, not because of the software, but rather due to inadequate computer capacity, lack of user training on current software releases and a lack of management reporting tools.

* A new service bureau contract would result in a long-term commitment, which might limit BANK's business options.

With the addition of two more motivations (e.g., avoiding a conversion and no long-term contract), facilities management was then considered. This arrangement was suitable to BANK for several reasons, including:

* The proposed facilities manager would assume the costs and responsibility for hardware upgrades, personnel and software license fees.

* The current customized software could be maintained and applied to future releases.

* No conversion would be necessary because the current software would be supported on-site, but the personnel would now be employed by the vendor. The "new personnel"/vendor would now have responsibility for supporting the environment.

* BANK already had a long-term lease for the existing data center facility.

But only a long-term contractual commitment would create a cost-effective scenario for BANK. In fact, a shorter commitment actually increased BANK's current data processing costs due to short-term, high-priced equipment leases and a premium paid for short-term, but fewer, resources. Thus, BANK determined it was looking for a more flexible outsourcing arrangement that was also cost-effective. The resource management alternative, as it turned out, satisfied BANK's outsourcing motivations because:

* The vendor was willing to negotiate a flexible short-term contract, with reasonable penalties for mid-term cancellation and attractive long-term pricing options should BANK fulfill the entire contract commitment.

* Current software would be upgraded to the most recent version and software modifications could be reapplied, for a fee.

* No conversion was necessary except to relocate the software to the vendor's location.

* New software applications were available to BANK at a monthly fee, rather than an expensive software license.

* Costs were reduced, although not as significantly as with a service bureau arrangement, because of the short-term nature of the servicing contract.

Once BANK fully understood what its true outsourcing motivations were--cost reduction, short-term contract obligation and no conversion--the institution was able to negotiate an outsourcing arrangement that satisfied its motivations and allowed the vendor to continue its relationship with an important client.

In summary, each institution has a variety of options available when considering outsourcing. With a good understanding of what is motivating your firm to pursue an outsourcing arrangement, you can select the arrangement and vendor that compliments your business plan and nets the desired benefits.

Stephen Sprinkle, a principal with the Atlanta consulting practice of Deloitte & Touche, has served many major financial institutions and banking data servicers. Terrell Kemp, a senior manager also with Deloitte & Touche's Atlanta consulting practice, has assisted many financial institutions in the evaluation, selection and implementation of outsourcing and software solutions.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:outsourcing
Author:Sorinkle, Stephen; Kemp, Terrell
Publication:Mortgage Banking
Date:Aug 1, 1992
Words:3339
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