The days of lump-sum outsourcing deals and blunt offshore labor arbitrage are gone. The future is about disaggregating IT processes -- and then figuring who is best equipped to handle them and where they are located. Here's how to do it right.

Nandan Nilekani, CEO of the outsourcing firm Infosys and the man who inspired the phrase “the world is flat,” is pushing a new mantra that could become just as universal:

“Work will be done where it makes the most sense.”

Relaxing on the couch in his Bangalore office, Nilekani points out that his own company has offices in 39 countries around the world. And it’s not alone. Wipro, another large India-based IT services company, has eight offices in Europe alone, and TCS, the IT services arm of the Indian conglomerate Tata, has 10 development centers and 10,000 consultants in the United States and Canada.

Meanwhile, providers we identify as American are no longer so. IBM now has 53,000 employees in India (up from 4,700 five years ago), and Accenture (which is actually based in Bermuda) will soon have more employees in India than in the United States and delivers its infrastructure and hosting services from 15 delivery centers scattered in countries across the world, including China, Argentina, Slovakia and the Philippines. In other words, as sourcing has gone global, so have sourcing companies.

And it hasn’t just spread. It’s evolved. Sourcing isn’t just about finding cheap labor anymore. Yes, you can still take something, ship it offshore and probably save a few dollars. “But cost in and of itself isn’t going to get anyone a competitive advantage,” says Tom Sanzone, CIO of Credit Suisse.

The New IT Supply Chain

The new model is more refined and complex. Today, IT services companies take work, break it down into pieces, and perform each piece in the location that offers the best combination of skill, cost, quality and manageability. If, for example, a new insurance application requires frequent contact with underwriters in New York City, any of the emerging global providers can do it there. But if there is a component of that work that only requires cheap coders, these companies will do that component in China, or if they need to speak Spanish they’ll do it in Costa Rica or Spain. “This is the future,” says Nilekani. “IT is being disaggregated. Slice by slice, the whole model is changing.”

With change comes opportunity for CIOs, who can tap into the global network that the outsourcing companies are building to improve quality, gain the flexibility and agility to respond to business changes faster, and, yes, save money. The outsourcing vendors have spent the past several years establishing centers of excellence dedicated to specific tasks—Java programming or business intelligence, for example. This allows for economies of scale and maximizes the chances that someone will find a way to improve the process. It also means that outsourcers have assembled deep rosters of talent, organized by skill and experience, that most CIOs cannot match. “I can’t think of any IT organization that has skilled people just sitting on the bench,” says Alan Boehme, CIO of Juniper Networks. “What you are really talking about is building a variable cost model for your IT organization.”

To reap all the benefits that modern outsourcing can provide, CIOs need to start thinking like a service provider, says Dane Anderson, an analyst with Gartner. That means examining your own internal model for IT service delivery and breaking down the work into the most granular pieces possible, just like outsourcing companies are doing. “You have to look at your operating model and ask how it developed and for what reasons,” says Sanzone. “Then you need to ask yourself if it still makes sense in today’s environment.” It’s a grueling process that Sanzone says can take a team months to complete. But it’s worth it. Thanks to the evolution of the outsourcing industry, he says, “You have a chance to reinvent your operating model. That is what we are really talking about.”

Stop Outsourcing Problems

When a company first engages an outsourcer with offshoring capabilities, it is usually thinking one thing: reduce costs. True, the labor arbitrage can be staggering; an experienced full-time engineer in India, Vietnam or Eastern Europe costs about $30,000 a year, and only half that in China (U.S. programmers can cost as much as $90,000 a year, according to a 2007 salary study by Robert Half Technology, a staffing firm). Not surprisingly, many, if not most, companies end up saving money—at least up front—when they outsource offshore. Consequently, according to a recent McKinsey report, a large majority of outsourcing customers say that on the whole they are very satisfied with their offshore outsourcing initiatives.

But the initial cost savings often mask long-term problems. Most companies tend to outsource processes without examining their quality and efficiency. They generally hope—or contractually demand—that the outsourcer fix things for them. Indeed, after the first year of an engagement, McKinsey found, companies begin to focus less on cost savings and more on flexibility and agility. That takes time, money and management attention—and may blow away the initial cost savings. “If you are outsourcing a problem, it will still be a problem,” says Bill Homa, CIO of the supermarket chain Hannaford Bros.

Breaking down IT processes into discrete components and analyzing which ones you can or should do and which ones a partner with subject matter expertise should do lets CIOs avoid merely shifting bad processes to an external provider. “If the CIO paints all of his IT areas with the same outsourcing brush, he is going to fail,” says Joseph Rottman, assistant professor of IS at the University of Missouri, St. Louis.

Break Down the Work

Boehme knows how to break things up and parse the work sensibly. For example, at a previous job he had to build an order configuration management system. He had his own people do the requirements gathering since they understood the business and worked closely with the users. The design was done with a mixture of in-house staff and contractors. Three groups—one in India, a team of onsite contractors, and students at a local university—did the actual coding. Yet another group did the initial testing before his team did the final regression and load testing and finished the deployment. “It made sense to do it this way since we didn’t have all the skills in-house and we couldn’t move people off of other projects,” Boehme says. But he found that breaking down the work like this allowed the project to be finished 25 percent faster and 20 percent cheaper than if he had done it all in-house or outsourced it entirely. Plus, his team was able to keep architectural control and retain the intellectual capital the project created.

By understanding exactly what a process or task requires, CIOs can determine if they have the skills and the resources internally to do the project and if doing so would give their companies a competitive advantage. If not, an outsourcer can sometimes take better advantage of geographic location and a deeper bench of special skills to do the job. It’s a low-cost way to get the skills you need, in the place you need them, for as long as you need them. “If I have 20 testing resources working on PeopleSoft, I don’t have the volume” to get economies of scale and to quickly react to business changes, says Boehme. But outsourcers do. “And at the same time, because of the size of their organizations they have the ability to offer advanced training programs to those people as well,” he says.

How to Be Introspective

The first step to componentizing your IT department is to stop thinking of the various jobs IT does as functions, and start thinking of them as services. It sounds like semantics, but there is an important distinction: Functions describe something from the perspective of the person or group performing it, while services describe it from the perspective of the person or group who benefits. “What is a help desk after all?” asks Gartner’s Anderson. “It provides a service to internal users of IT.” Look across the rest of the department, he says. “Everything can be considered a service. You just have to figure out who the customer is.”

Once you adopt that mind-set, you are in a position to think about your IT department like a discerning shopper and not get distracted because something has always been done a particular way. That’s critical, because componentizing your IT department will require you to challenge assumptions and the status quo. CIOs need to break each of these services into discrete processes, and each process into tasks. (In outsourcing lingo, tasks are a subset of processes. For example, requirements gathering might be a process; talking to users would be a task.) In some cases processes and tasks will overlap. In others, you will find extraneous or poorly performed steps. That’s one of the benefits of the exercise, says Louis F. Rosenthal, executive vice president of ABN Amro Services. “I don’t think that a company can be rigid with its own processes and expect to get maximum value from a strategic sourcing partner,” he says. CIOs need to do more than merely evaluate the processes they have; they must think about the processes they want to have in the future.

It’s not enough just to identify these processes, however. They need to be broken down into specific tasks. For example, a company may have a group of programmers who understand every aspect of the business and turn out amazing applications that give the company a competitive advantage. Outsourcing the entire application development process in this case would be a nonstarter. But if you break down the application development process, you end up with a list that looks something like: requirements gathering, functional design, physical design, building, testing and deploying. Maybe the team isn’t great at testing. Or maybe there is a testing group somewhere in the world that can perform that task cheaper and more efficiently. Breaking processes into tasks gives you the opportunity to make these kinds of decisions.

The End of the Billion-Dollar Outsourcing Deal

Understanding your IT department at this level also makes you a better outsourcing customer. Rather than taking large pieces of IT and outsourcing them to one vendor in a megadeal that essentially marries the company to that partner, CIOs can use the insight they gain from the analysis to find the right partner for specific processes and tasks. In fact, Boehme suggests that CIOs should have at least two partners, and make them compete for your dollars.

Jimmy Harris, managing director of infrastructure outsourcing for Accenture, agrees, although he warns of a few potential problems. First, he says, it isn’t a good idea to divide a process between vendors, despite some vendors’ claims that they can work together. Also, he says, CIOs should not spread out the tasks that form a particular process too broadly, because it just adds complexity. Workers are less motivated because they feel as though they have less invested in the final product. And, he adds, “If you have to engage in thousands of low-level communications because you broke up the work at too fine a level, you are going to lose stuff.”

In fact, in order to combat the complexity that comes from spreading your IT processes and tasks around the world, some CIOs have created a high-level position to keep track of outsourcing vendors and the projects that they are working on. “It’s an emerging function that may not have existed at a global level before,” says ABN Amro’s Rosenthal. “Vendor management becomes much more important now. [Having that group] helps us facilitate business decisions in ways that we didn’t have to before.” Applying this kind of methodology to your IT operations will let you see what components of your organization can be moved. By tapping into the skills network that outsourcing companies have built, you can react to new requirements faster. It’s enough to let even the smallest companies act like a big company.

“We’ve been able to get our staff to move up the value chain,” says Homa, reflecting on the impact that taking advantage of the new outsourcing world has had on his department. “It’s allowed us to raise our game.”

Ben Worthen writes about emerging business trends.