Management Update: Application Outsourcing Trends for 2003 and 2004

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1 IGG R. Terdiman, A. Young Article 5 February 2003 Management Update: Application Outsourcing Trends for 2003 and 2004 The application outsourcing market now includes a broad range of services. Understanding key trends and drivers shaping the market will help enterprises to better plan, implement and refine their sourcing strategies. The application outsourcing market now includes a broad range of services. Understanding key trends and drivers shaping the market will help enterprises to better plan, implement and refine their sourcing strategies. Application Outsourcing Market Overview Growing Scope The application outsourcing market began when enterprises employed third parties to support their complex, customized legacy applications that were built for mainframes. It has evolved to include developing and deploying client/server and packaged applications, and, more recently, Web-based applications that enable e-business connectivity. Application outsourcing services have also expanded to include ongoing maintenance and management (including optimization) of applications, both of which are critical elements of the applications life cycles. External service providers (ESPs) are expanding their application outsourcing portfolios to include services such as: Portfolio rationalization Business intelligence Data warehousing Packaged application support Application integration ESPs have also responded to enterprises requirements for full life-cycle application support by including project management, continuous enhancement and benchmarking against industry standards, such as the Software Engineering Institute s Capability Maturity Model and the Gartner Entire contents 2003 Gartner, Inc. All rights reserved. Reproduction of this publication in any form without prior written permission is forbidden. The information contained herein has been obtained from sources believed to be reliable. Gartner disclaims all warranties as to the accuracy, completeness or adequacy of such information. Gartner shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof. The reader assumes sole responsibility for the selection of these materials to achieve its intended results. The opinions expressed herein are subject to change without notice.

2 International Organization for Standardization 900x family of standards. Some ESPs application outsourcing portfolios also include product rationalization and global skills sourcing. Growing Market Application outsourcing contracts encompass an array of services, including application development, management and enhancement. Through year-end 2007, Gartner expects the market for application management services to grow at a compound annual growth rate of 11.6 percent. Although that is slower than in the 1990s, it will exceed growth in the markets for application development (4.3 percent) and application deployment (4.6 percent). A critical need exists for ongoing application support which is approximately 30 percent of the total cost of ownership during the life of an application is for its maintenance and management. Aggressive Competitors The strong adoption of application services has resulted in new, aggressive competitors in the application outsourcing market. The main players are: Traditional IT service companies, consultants and system integrators, which are seeking to evolve their conventional outsourcing offerings to include application outsourcing services Software application vendors (such as Oracle, PeopleSoft and SAP) Application services providers (ASPs), such as Corio and Appshop Offshore ESPs, which are the most formidable competitors in the application outsourcing space In implementing their sourcing strategies, enterprises must carefully review the benefits and drawbacks of the different types of vendor and their application outsourcing strategies. Growing Demand for Standardized Solutions The need for enterprises to develop customized solutions has declined as new options for standardized solutions have matured. Packaged applications are one example, although enterprises tendency to customize ERP (enterprise resource planning) solutions has negated some of those solutions benefits by creating highly complex and difficult-to-manage application suites. The initial hype of the ASP market did not translate into widespread market adoption of standardized solutions charged for on a usage basis. However, the ASP concept has introduced a fundamental market change that is gradually evolving to satisfy enterprises needs for speed and cost savings. Gartner believes that the use of alternative hosting models such as those offered by ASPs and business service providers in which services are essentially embedded in the application are growing, although they are not garnering much public attention. These trends will strengthen the overall growth of the application outsourcing market. Growing Demand for Vertical Solutions

3 Driven by their desire for competitive differentiation, enterprises increasingly are looking for niche application outsourcing solutions, particularly those aimed at vertical industries or subindustries. Enterprises are also looking for those solutions to be delivered by ESPs with a deep understanding of their particular business challenges and problems. ESPs are attempting to satisfy those demands, but the most-complete solutions are provided only by established, global ESPs. To enhance their value, some emerging offshore players are attempting to organize along industry lines so that they can offer vertical application outsourcing solutions. Cost Reduction Focus The economic slowdown is causing enterprises to focus on reducing costs in every aspect of their business. Cost reduction is an underlying objective of application outsourcing contracts. Most ESPs face unprecedented pressures from enterprises to deliver reduced operation costs through outsourcing. However, the economic climate is making enterprises extremely cautious. That has delayed contract signings for some large, long-term outsourcing contracts. Although some application outsourcing contracts that are part of larger outsourcing deals have been affected, several focused, selective, application outsourcing-only contracts that are aimed at cost reduction have been signed. Offshore Outsourcing Is Transforming the Competitive Landscape Growing Offshore Outsourcer Use Application outsourcers claim that they can achieve efficiencies and deliver cost savings by applying technology, disciplined processes and methodologies. Today, however, ESPs are being forced by their clients to turn to alternative, lower-cost labor markets to supplement local staff (on-site and domestic). Enterprises usually won t ask ESPs to bid unless the ESPs can show that they have access to low-cost, offshore resources. By offering alternative nearshore (that is, outsourcing to countries close to the location of the client) and offshore pricing options, ESPs can more effectively address their clients pressing demand for lower costs. Enterprises are also more willing to use nearly unknown offshore ESPs for application outsourcing because they believe that will reduce application total cost of ownership. Application outsourcing requests for proposals routinely are sent to leading offshore ESPs (primarily firms in India) as well as established U.S. vendors. Offshore vendors have responded aggressively to the current focus on cost reduction often by bidding lower and lower rates to win desired customers. However, in their desire to reduce costs as much as possible, some enterprises believe that success in application outsourcing depends on finding the offshore ESP that can provide the lowest-cost programmers. Gartner believes that driving down per-unit labor costs is too tactical and short-termfocused. It does not differentiate among ESPs with the most highly qualified resources and, in the long term, will result in poor service delivery. As usual, You get what you pay for. U.S. ESP Response to the Offshore Challenge Leading U.S. ESPs have responded to the challenge posed by offshore ESPs by including offshore solutions in their portfolios. They know they have to provide details of their global capabilities and resources if they are to compete more effectively against offshore ESPs. Since early 2000, several U.S.-based ESPs have developed offshore capabilities by doing the following:

4 Investing in their own offshore facilities. These ESPs rely on their internal management teams, staffs and processes to effectively leverage a global network of resources. Forming strategic alliances with offshore ESPs. These relationships, usually joint ventures, allow each partner to add value by bringing their core expertise to the alliance. From Offshore Sourcing to Global Delivery Most IT managers equate offshore sourcing with the procurement of low-cost IT and back-office services (for example, call centers) that use resources in a different country (primarily India). Thus, offshore ESPs previously might have been used to provide people resources for year 2000 projects or to augment enterprise staff. However, the offshore market is evolving toward becoming a component of a global delivery model, in which enterprises use a combination of on-site, onshore, nearshore and offshore resources to ensure that they have the right skills at the right price at minimal risk. Global delivery first will be used for application services, then for most other IT services. ESPs with a global delivery model will offer customers a wide variety of resources from countries worldwide. Enterprises will be able to choose from a broader range of application services. Resistance to global delivery will steadily decline as the cost efficiencies and resource advantages of global sourcing become more compelling, and as other risks factors such as security, political uncertainty and others are minimized. Application Outsourcing Sourcing Strategy Trends Growing Focus on Process Quality Enterprises and ESPs are increasingly paying attention to the process capability of ESPs, measured in terms of conformance with a relevant quality standard. They correctly assume that using a standardized approach for developing software likely will be more successful than a random development process. The greater emphasis on development process quality standards is being driven by Indian ESPs, which believe that better quality processes will lead to reduced costs for their clients (and will make them credible players). Although quality is an important factor in selecting an ESP, it does not necessarily translate into lower costs. The most widely used quality standard that enterprises can use to assess an ESP s process capability is the Capability Maturity Model. Emergence of Preferred Service Providers Enterprises are consolidating their use of application services by placing contracts with several primary application outsourcing vendors that understand their business, have track records and with whom they can form more-trusted business partnerships. Their goal is to reduce a large number of ESPs to a more-manageable, preferred service provider list possibly two to four ESPs. ESPs with industry-specific expertise and a strongly differentiated value proposition have an advantage in these more-exclusive relationships. Some enterprises enter into master service agreements with their preferred service providers to ensure flexibility for add-on work. Changing Demand for Application Services

5 Since mid-2001, enterprises have cut back on discretionary application development projects, favoring longer-term application management services, serial enhancements and other application services that could reduce costs or improve bottom-line performance. However, enterprises increasingly are willing to invest in Web-enabled interfaces, construction of data warehouses and migration of architectures to new technologies such as Java-based technologies. Many of these new projects are included in application outsourcing contracts. Integrating E-Business Applications Enterprises have spent enormous amounts of time and money on launching e-business applications. They now are greatly involved with deploying and managing Web-based applications. As e-business matures and these applications slowly become the next generation of legacy applications, enterprises will need to integrate them with back-office systems. Enterprises will consider ESPs that can provide e-business skills as part of their application outsourcing solutions. Growing Need for Packaged Application Outsourcing Enterprises have made significant investments to deploy enterprise resource planning packages; some have underestimated the high costs of ongoing support. This has led enterprises to outsource the deployment and management of packaged applications, particularly those from SAP, PeopleSoft and Oracle, and to a lesser extent, from J.D. Edwards and Siebel Systems. Increasingly, packaged application services are being offered by offshore ESPs as well as global ESPs. Offshore ESPs naturally focus on those aspects of packaged application outsourcing that lend themselves to offshore work for example, in SAP environments, the provision of Advanced Business Application Programming and SAP Basis skills. Most offshore ESPs report continuing growth in this type of packaged application outsourcing. Bottom Line By understanding key trends in the applications outsourcing market, enterprises will ensure that they have the most-appropriate sourcing strategy and an accurate view of the competitive landscape. Today s extremely cost-focused approach to application outsourcing will moderate soon, the pendulum will swing toward aligning the value of application outsourcing with business performance. In the near term, enterprise sourcing strategies will involve evaluating nearshore and offshore application outsourcing solutions, with a sharp focus on cost reduction. Written by Edward Younker, Research Products Analytical sources: Rita Terdiman and Allie Young, Gartner Research For related Inside Gartner articles, see: Management Update: 2003 Predictions for Offshore Sourcing, 27 November 2002

6 Management Update: Business Process Outsourcing Market Trends in 2002, 27 February 2002