Business IT: Rent or Buy?

By John Clyman  |  Posted 2004-10-19

Business IT: Rent or Buy?

When you need a place to live, youve got plenty of options to choose from. You could build a home from scratch to your exact specifications—and wait a year or more until its ready. Or, you could rent an apartment, reducing your up-front capital expenses, lead time, and maintenance responsibilities in exchange for reduced flexibility and control over the particulars of your abode.

Enterprise applications come with a similar range of choices. Over the past decade, most enterprise investments followed the do-it-yourself model: Put foundational infrastructure in place, purchase software licenses, pay third-party consultants to perform extensive customization, and then maintain it all. But increasingly, companies are turning to application outsourcing as an alternative. Outsourcing promises benefits like reduced risk, lower capital and maintenance costs, improved responsiveness, and simplified deployment. It also helps eliminate overcapac-ity and provides affordable access to best-of-breed capabilities.

Whether youre subscribing to Web-based applications, on-demand services like those popularized by, or utility computing infrastructures such as those promoted by IBM and Sun Microsystems, there are countless variations on the outsourcing theme: renting software instead of buying it. All offer new ways of letting companies balance their internal and external IT investments to meet their business requirements.

As a technology or business manager, how can you cut through the hype to tell whether and where application outsourcing might be right for your organization? And what caveats should you keep in mind?

ZIFFPAGE TITLEPutting Outsourcing in Perspective

Putting Outsourcing in Perspective

The term outsourcing carries a potentially confusing variety of connotations. One outsourcing mechanism in particular—offshoring software development projects to India or other countries where highly skilled labor is available at low cost—has received extensive attention and sparked relentless controversy. But thats hardly all that outsourcing entails.

In the most general sense, the decision to outsource is just a variation on the make-versus-buy question that managers confront constantly. For any given business function, does it make more sense to allocate capital and deploy staff internally? Or would the company be better off acquiring it from an external source?

Even outside the technology space, the balance has changed radically over time. A century ago, vertical integration was considered essential in many industries; Ford Motor Co. owned rubber plantations in Brazil to provide the raw materials for manufacturing tires for its vehicles. Today, the notion of maintaining such peripheral capabilities seems almost comical: better to delegate the responsibility to specialized suppliers with the requisite expertise, as is common when companies hand off payroll processing to service providers like ADP.

Outsourcing within the IT world isnt a new phenomenon, either; mainframe time-sharing systems date back to the 1960s. More recently, Web hosting and co-location have become so commonplace that theyre passé. But lately, the idea of migrating significant applications from an in-house data center into the hands of a third-party provider has gained appeal.

Its still a small market, totaling around $2.3 billion worldwide in 2003, according to Amy Konary, director of pricing, licensing, and delivery at research firm IDC. Thats tiny compared with packaged software sales, which are estimated at about $200 billion. But its also growing at a rapid 25 percent annual rate, leading Konary to project that spending will reach $7.2 billion in 2008. And perhaps most important: Even if the size of the market is small, the potential benefits to companies that embrace outsourcing are large.

ZIFFPAGE TITLEProblems With Enterprise Applications


Problems With Enterprise Applications Today

IT organizations face several problems that outsourcing addresses. Expense is the first: Enterprise IT is costly, not just in hardware purchases and software licensing costs but in maintenance, support, and staffing—all the factors that are rolled up into the so-called TCO (total cost of ownership).

The expense is exacerbated by the necessity to overinvest in the data center to accommodate peak CPU, storage, and bandwidth needs that may be reached only infrequently. (Having a fixed infrastructure also gets in the way when your operation exceeds capacity. How do you add further capacity in a pinch?) Additionally, those investments often require significant up-front capital expenditures that must be depreciated over an extended period, not expensed as they occur.

Beyond the direct costs, theres also the challenge of finding and retaining highly skilled IT staff for niche needs. Maybe youre a Windows shop that needs occasional Unix expertise, for example. Or you need to support legacy applications but no longer have the domain knowledge in-house. Perhaps you want to tap the best-of-breed experts in a particular field.

Implementing enterprise applications takes time, too, and the risk of failure is significant. Additionally, rapid changes in technology can make maintenance an ongoing hassle and slow a companys ability to adapt to new conditions. For nontechnology companies in particular, the reality may also be that IT, though important, is not a crucial competitive differentiator.

Smaller operations have even more basic problems. With an IT staff of one or two and a budget already stretched to the limit for maintaining network connectivity and databases, where do you turn for additional resources?

With these problems in mind, major consulting operations like IBM Global Services, EDS, and Accenture regularly ink multibillion-dollar deals in which they outsource entire divisions of large enterprises. But not all outsourcing efforts have to be so grandiose. On a smaller scale, a variety of providers let companies rent, in effect, items such as computing capacity, applications, or services on a pay-as-you-go basis.

Unraveling the available options can be confusing. Part of the problem is that the basic terminology is far from standardized. Here are some of the terms that occur frequently, and the contexts in which they appear.

Utility computing. A utility is a commodity thats available as needed via a standardized interface. You can plug any appliance into any electrical outlet, more or less, and get access to the power supply. Utility computing aims to make computational, network, and storage resources available on demand. Sun Microsystems N1 software, for example, "virtualizes" several physically distinct machines so that they behave as a single resource.

Other companies, such as EMC, HP, IBM, Verari, and Veritas offer similar capabilities. Utility computing may be appropriate for custom or customized applications of the sort that you might otherwise run in-house.

The sources of a true utility product would be fungible—you dont know or care which power plant generated the electric-ity you consume—though no IT utility today yet approaches that ideal. Its not particularly in a vendors interest to commoditize its own products to such an extreme.

Grid computing. The term grid applied originally to the large arrays of comparatively cheap commodity processor subsystems used in some supercomputer designs, as well as to the loose confederation of machines whose spare CPU cycles are harnessed by distributed-processing projects, like the SETI@Home initiative. Now, though, grid computing is sometimes used as a rough synonym for utility computing.

On-demand. Often used to describe hosted software, the term on-demand is particularly prevalent in the CRM (customer relationship management) market, where companies like NetSuite,, and SalesNet offer Web-native approaches, unlike more traditional client-server implementations. (For a comparison of leading on-demand CRM products, see "CRM on Demand: Have It Your Way," First Looks, July, page 62.)

However, the term on-demand has a second meaning, closer to that implied by utility computing. As Dean Douglas, vice president of IBM Global Services puts it, "On-demand is about having the capability—tech infrastructure, software, et cetera—available as you require it."

Application service provider (ASP). ASPs are, loosely speaking, companies that host software and make it available remotely. They can be further divided into two subcategories: those that host packaged applications that could be installed in-house (like mail servers or accounting applications), and those with Web-native applications like on-demand CRM.

Managed service provider (MSP). As a subset of the application service provider category, MSPs typically offer network management and monitoring services. Managed security service providers offer services such as intrusion detection, perimeter antivirus filtering, and managed firewall support.

Software as a service and pay-as-you-go IT. These are variations of the on-demand and ASP theme of subscribing to software. Software as a service sometimes carries the further connotation that functionality is exposed as a collection of Web services components. In this way, companies like and Google, both of which publish Web services APIs (application programming interfaces), could even be said to provide a limited form of free software-as-a-service infrastructure.

Amazons API, for example, lets developers access catalog data and manipulate shopping carts using REST (Representational State Transfer) or SOAP (Simple Object Access Protocol) queries—essentially exposing Amazon functionality via Web services for anyones use. Googles API, which is currently limited to noncommercial use, provides an interface to Googles search results, page cache, and spell-checking engine.

Although Web companies like these are best known for being destinations in their own right, some analysts think that someday such companies may be well positioned to provide broad software-as-a- service capabilities. Could Googles Gmail, for example, be an opening salvo, just the first of many on-demand applications that the company might ultimately launch?

Regardless of the terminology used, its clear that a wide variety of capabilities are amenable to outsourcing. Bill McNee, founder and CEO of Saugatuck Technology (a Westport, Connecticut–based research firm) believes that the applications most likely to be outsourced in the near future are those "where configuration can meet your needs, rather than tremendous amounts of customization."

The most popular applications under consideration today are those that manage personnel and finance-related issues: benefits and personnel administration, travel services, payment processing, payroll, and the like. CRM, SFA (sales-force automation), ERP (enterprise resource planning), and customer service applications are much lower on the scale, even though CRM has probably the highest profile.

ZIFFPAGE TITLEBenefits of Outsourced Applications

Benefits of Outsourced Applications

The most obvious factor driving outsourcing is its potential for reducing costs. Infrastructure overcapacity is a big problem: Saugatucks research indicates that many businesses have 50 percent or more surplus IT capacity that remains unused most of the time. Economy of scale is another advantage that outsourcers offer: A data center serving 100 different customers is likely to cost less per customer than would 100 separate data centers, each serving a single customer. The economy of scale is further visible in outsourced environments that implement multitenant architectures, where multiple users are each sharing private instances of a single application.

And yes, fundamental cost structures are a factor as well: Labor rates, real estate expenses, and taxes may be substantially lower in out-of-the-way geographic locations. (Theres a reason that Silicon Valley companies locate call centers in places like Nebraska—or India—rather than in the hugely expensive local market.)

If youre using a Web-native application, theres an additional benefit: All you need is a Web browser to access the application, which means no specialized client software to install. Furthermore, updates to the application are automatic; theres no need to push a new client out to dozens or hundreds of machines. Although browser-based applications typically havent offered the rich user experience of native GUI applications, companies are getting better at using JavaScript and dynamic HTML to enhance the richness of Web applications with features such as drag-and-drop. Security across the wire is usually provided via SSL support already built into browsers.

A downside of Web-based applications is that you cant use them off-line. Many vendors therefore provide some kind of off-line client software as an alternative access mechanism. But in our experience, these dont usually offer the full range of features available in the online application.

Whereas traditional CRM applications often entail extensive customization—to the extent that some analysts recommend budgeting $3 in consulting and services for every $1 in licensing fees—on-demand applications typically work off a prebuilt foundation that can be configured more than customized. Yet companies like are beginning to reset the customizability goalposts with user-extensible data schemas, sophisticated multilanguage support, and full-blown APIs. In fact, CEO Marc Benioff claims, "We dont make a CRM app any more, we make a tool" that lets companies create whatever database-driven application they want.

Yet the fact that many outsourced applications do provide so many capabilities on top of multitenant architectures means that they offer the advantage of rapid provisioning of new services, so companies IT departments can become more nimble. The model also reduces risk. Companies purchasing outsourced services dont need to worry about the capacity of the infrastructure and what to do if demand varies dramatically. Nor do they need to devote resources to managing internal staff.

Application outsourcing may thus hold particular appeal for small and midmarket companies—those with a few dozen to a few hundred employees. Such companies often need complex, robust IT systems but dont have the deep enterprise IT resources and expertise that larger companies can apply to the problem.

But the appeal of application outsourcing undoubtedly extends to both much smaller and much larger businesses as well. Many vendors offer small-scale versions of their products with low monthly per-seat pricing, so you pay only for what you use. At the top end, in terms of the scope and the costs of outsourcing agreements, the skys the limit.

ZIFFPAGE TITLERisks and Challenges

Risks and Challenges

Experts say that cost savings loom large when companies are considering outsourcing and urge them to beware of making decisions solely on the basis of cost. Control issues certainly merit major consideration. Another company is going to be responsible for your critical business systems; are you willing to trust it? Can it deliver the features, performance, security, support, and disaster resilience and recovery that you demand? Will the company be in business five years from now, or could it leave you stranded?

Application outsourcers live and die by their reputation for reliability, security, and data integrity, so those that persist are likely to get it right. But dont let that be a substitute for doing your own due diligence. Similarly, chances are good that youll want an SLA (service level agreement) that spells out the kind of performance, availability, and support you can expect. In fact, companies such as PremiTech provide tools to help measure and report on application responsiveness so you can verify that hosts are in compliance with your SLAs.

When evaluating application outsourcing, be sure to consider your transition plan: How youll migrate data into the new system, test it, and train staff. Dont forget to think about what happens when your outsourcing arrangement ends, either. What are your options for renewal? How will you be able to extract your data if and when you select a different provider? Vendor lock-in, in other words, should be at least as much a concern here as it would be for internal systems.

Think how your outsourced application will integrate with your other business systems and particularly with other apps you might outsource—perhaps to different partners—in the future. Today, interoperability between outsourced applications is likely to be somewhat limited, though the spread of Web service architectures should improve the possibilities over time.

And dont forget the human angle: the impact that outsourcing may have on your companys people. Employees are likely to be wary that outsourcing will mean lost jobs. Executives may be resistant to the perceived loss of institutional power if their staff or budget is cut dramatically.

Rather than simply jump on the latest bandwagon, its important to clarify your business rationale for outsourcing. As Ian Dix, senior vice president of marketing at the outsourcing company Virtela, explains, outsourcing "has gotten so much attention that companies are doing it simply because they believe their competitors are doing it—and theyre not doing the hard-core analysis, asking what are we trying to achieve by doing this."

Its similarly important to make sure you have a strong relationship with your outsourcing partner and the people to manage the process; the goal should be delegation of a function, not dereliction of responsibility. IDCs Konary says, "When people think about outsourcing, they think theyre just going to hand [things] over to someone and not have to think about it anymore." This is a big oversimplification, especially for larger, more complex outsourcing deals.

ZIFFPAGE TITLEWhat the Future Holds

What the Future Holds

With companies increasingly seeking to maximize their IT return on investment and focus on core competencies, a continued migration to IT and application outsourcing seems almost certain. Were sure to see new types of applications being offered in hosted environments, as well as new challenges—and new innovations—in areas such as metering and billing, interoperability, and management.

Salesforce.coms Benioff likes to forecast the end of software as we know it—a day thats still far off, if it arrives at all. Its easy to see typical database-driven, client-server-style business applications moving to an on-demand model, but its harder to imagine something like content creation following the same path: Can you imagine Adobe Photoshop as a Web app?

History shows us that the incredible proliferation of the PC did not spell the end of mainframe software, although the PC unequivocally stole the spotlight. Still, for many types of business software, the on-demand model is sure to grow in appeal. And even today, it offers advantages that make it well worth your consideration.

Our contributors: John Clyman is a consultant and contributing editor of PC Magazine. Cade Metz is a senior writer, and Molly K. McLaughlin is an intern. PC Magazine Labs lead analyst Sahil Gambhir and associate editor Michael J. Steinhart were in charge of this story.

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