WHY NOT FARM OUT YOUR COMPUTING? Hiring another company to do your data processing can save you big bucks. Some say it's the biggest trend since the PC burst on the scene a decade ago.
By David Kirkpatrick REPORTER ASSOCIATE Ricardo Sookdeo

(FORTUNE Magazine) – AT ITS HUGE manufacturing complex in Rochester, New York, Eastman Kodak operates its own steam, electricity, and water purification plants. Kodak firefighters stand on call at Kodak firehouses. Bright yellow-and red-striped Kodak locomotives chug back and forth over 17 miles of Kodak tracks. But the company's self-sufficiency stops at its computers. In 1989, Kodak sold off its mainframes to IBM and hired Big Blue to do its data processing for the next ten years. The move startled computer managers across corporate America. No company of Kodak's size and prominence had ever turned over its computers to an outsider -- a practice called outsourcing. Kathy Hudson, Kodak's director of information systems, explains why the company did it: ''IBM is in the data- processing business, and Kodak isn't. IBM runs our computer center as it's supposed to be run -- as a profit center rather than a cost center.'' Kodak is plainly onto something. Now, two years later, information systems consultants say that about half the major U.S. corporations they work with have launched or plan to launch a formal analysis of whether outsourcing makes sense for them. Among those that have already followed Kodak's lead: National Car Rental System, Cummins Engine, the Matson Navigation shipping line, natural gas producer Enron, and Signet Banking of Richmond. U.S. businesses spent $7.2 billion on outsourcing of computer operations in 1990; by 1995 the annual amount will more than double, to $15.2 billion, according to Input, a computer market research firm in Mountain View, California. Says security analyst Stephen McClellan, who follows computer services and software for Merrill Lynch: ''Outsourcing is by far the biggest trend in computing since the development of the PC ten years ago.'' For CEOs and directors of companies that lay out hundreds of millions of dollars each year for data processing, outsourcing has powerful appeal. Computers typically gobble 3% to 5% of an industrial company's operating budget, and often more at service companies. Shaving 10%, say, can make a significant difference to the bottom line. Small wonder that outsourcing salesmen sometimes bypass data-processing managers to call on the boss directly and ask, ''How would you like to save $100 million?'' The biggest in the business is Electronic Data Systems, General Motors' $6- billion-a-year subsidiary. It holds nearly half the major long-term outsourcing contracts (see table). Generally, the outsourcer buys a customer's computer hardware and hires all or most of the employees who have been running it. EDS paid Enron some $6 million for its computers, software, and data- transmission network, says Enron CFO Jack Tompkins. The Dallas computer services giant also hired some 550 Enron employees -- mostly computer operators and programmers -- at comparable wages and benefits. Nobody was fired, Tompkins says. GROSS PROFIT MARGINS are generous in this business -- often 25% to 30%. For IBM, outsourcing recalls a bygone era of fat profits, when instead of selling its computers and punch-card machines to customers, it leased them, complete with service. (In an antitrust settlement in 1956, IBM agreed to start selling equipment and temporarily deemphasized computer services.) IBM has high hopes that outsourcing earnings can help it counteract declining margins on hardware. Big Blue recently organized a subsidiary, Integrated Systems Solutions Corp., to handle the business. Its president, Dennie Welsh, says IBM expects outsourcing to grow faster than any other part of the data-processing industry. Says he: ''We want services to be our core business, and outsourcing is our biggest service offering so far.'' Yankee Group, a Boston technology consulting firm, estimates IBM's 1990 outsourcing revenues at $3.9 billion. , Other major outsourcers include AT&T, Andersen Consulting, Computer Sciences Corp., and Digital Equipment Corp. None of the companies FORTUNE spoke with would reveal details of their contracts. Normally an outsourcer charges a fixed annual amount, plus additional fees based on processing volume. Says John McGeachie, an information management consultant for Arthur D. Little: ''In an uncertain world, people want to be able to control their costs. That's very hard to do if you own lots of mainframes. Outsourcing lets you pay each time you process a piece of data.'' The customer can also save on taxes: While hardware must be depreciated over three to five years, outsourcing fees are deductible as a current business expense. Tompkins says Enron expects to save $200 million in this decade -- 20% to 24% of total computing costs, according to a consultant familiar with the company. Corporations see other benefits. As computers evolve, many companies decide they lack the resources to keep up with new information-processing technology. By aligning themselves with the like of IBM or EDS, they benefit from economies of scale. The outsourcers often save money, for example, by pumping several companies' data through a single mainframe. Customers also gain access to a pool of experienced techies. Says EDS founder H. Ross Perot, the outsourcing pioneer who now heads Perot Systems: ''Our guys are like sailors who've been around the Horn 20 times. They command respect.'' Kodak and Enron contend that outsourcing makes sense strategically as well as economically. Kodak believes it should focus on what it does best and farm out other functions, Hudson explains. The photo giant does not consider running mainframes one of its ''core competencies.'' Says Tompkins of Enron: ''Just as people talk about major oil companies, our goal is to become the first natural gas major. Nothing in that vision says we want to be a provider of information services.'' Roughly half the companies that opt for outsourcing see it primarily as a way to save money in tight times. Continental Airlines signed up with EDS after it went into Chapter 11. Many outsourcing clients are distressed banks and S&Ls. Says Alan Stanford, national director of information technology consulting at Ernst & Young: ''Some companies see an immediate bonanza -- they can sell assets to an outsourcer, get cash, and right away their expenses will be reduced.'' Hudson says Kodak has already had dramatic results. Capital spending for computing has dropped 90%, and operating expenses have fallen 10% to 20% -- for a combined annual saving of around 40%. That could amount to as much $130 million over ten years, based on outside estimates of Kodak's computer budget. More important, by putting itself in IBM's hands, the company avoided a potential computing crisis. Before IBM arrived in 1989, Kodak's plan to consolidate its five North American mainframe installations in a single, massive Rochester computer center was well behind schedule. Many of the company's 25 operating units were finding themselves more and more dependent on computer power. The group that supplies chemicals and paper to photo dealers, for example, has installed data links to photo labs in order to keep track of their stock and let them reorder automatically. The copier division uses a 24-hour computer system to track service requests and dispatch repair people. Impatient with the pace at which the corporate data-processing organization was adapting to such changes, and hoping to save money at the same time, three operating units withdrew work from Kodak's mainframes and bought systems of their own. By bringing in IBM, Hudson speeded things up; she figures Kodak would have taken until at least 1994 to complete the new data center. Some 50,000 employees already tap into the computers at the vast (189,000 square feet) center. Its machines handle Kodak's financial databases, payroll, personnel, and customer records, and also track products as they move through manufacturing and distribution. To serve the operating divisions better, Hudson reorganized her so-called applications support staff -- the squads of programmers who customize software, deal with emergencies (such as data loss when a storage disk crashes), and fix bugs that crawl out when a program is put to new uses. Hudson dispatched some 800 Kodak programmers to operating groups. She says, ''Our focus is now the business application of technology, not the technology itself.'' Kodak has asked the divisions to try the new arrangement for two years, but they are free to set up their own systems if they choose. Nobody doubts that Kodak got a good deal, if only because IBM can't afford to let such a high-visibility assignment go wrong. Frank Palm, who heads IBM's Kodak operation, says he generally buys hardware with Big Blue's name on it. But he recently demonstrated his flexibility when a Kodak subsidiary decided it needed workstations from Sun Microsystems to run a departmental database. ) Palm won the right to run the Sun computers by bidding less than it would have cost the division; he says economies of scale give him the advantage.

An unexpected benefit of the IBM presence, says Hudson, is a new in-house frugality: ''In the past we sometimes said, 'That's just Kodabucks,' '' when one part of Kodak paid another for computing services. ''But now we send the money to IBM. You'd be amazed how big a difference that makes in people's attention to costs.'' NATIONAL CAR RENTAL has carried outsourcing a step further. It agreed to pay EDS $500 million over ten years to take over its corporate data center, its reservation system, and the terminals at the service counter -- and to hire the 200 people who program and run the machines. Few businesses depend more heavily on computers than rental car agencies. National tries to distinguish itself from archrivals Hertz and Avis, for example, with its so-called Emerald Aisle Smart Key. The system, similar to a network of automated teller machines, allows preferred customers to check cars in and out with special credit cards, bypassing the lines at service counters. National is also setting up a computerized system that uses tiny radio beacons to keep track of cars in its airport lots. Says chief information officer Jack Livingston: ''Computers are critical to our operation and becoming more so every day. But because we have expanded our use of technology so much and plan to continue, we needed to gain much greater control over that technical environment.'' How can National gain control by giving up its computers? Livingston says outsourcing made sense in part because the company had difficulty hiring programmers. It offered them higher pay than other employees but still failed to attract enough. Now, says Livingston, he can tap EDS: ''I haven't lost 200 people, I've gained 50,000.'' Adds Chief Executive Vincent Wasik: ''We understand what we want from the technology, and now we can direct the people from EDS to implement it. Instead of worrying about losing one of our top programmers, we can concentrate on how we can launch a new product in 1992.'' But how wise is it, really, to entrust your electronic brains to outside hands? After all, these are the very computers you depend on increasingly to connect your company to customers and suppliers, to speed communications among your managers, and to design and test new products. Computer consultants give outsourcing mixed reviews. One undeniable benefit: It strips away some of computing's mystique. Corporate information officers have not always been eager to break down their costs for top management. Says Len Bergstrom of Real Decisions Corp., a computer consulting firm in Darien, Connecticut: ''The best thing about outsourcing is that people now consider the information technology function as a business, and businesses can be rated and compared. It's not an art or a science anymore.'' Outsourcers can come in and guarantee to provide a set amount of processing at a set price. Experts such as Howard Anderson, managing director of Yankee Group, think that some companies have gone too far. A business should never part with its programmers, he maintains, lest it lose the ability to create software that sets it apart from competitors: ''Companies that don't retain the staff to do applications development are putting their future at risk.'' Adds John McGeachie of Arthur D. Little: ''For example, EDS cannot know as much about the car rental business as National does.'' Michael Hammer, a consultant in Cambridge, Massachusetts, worries that too many companies are relinquishing their best technical people -- the very employees who can figure out how the company should extend its technology. ''It's akin to outsourcing your marketing department or your strategic planners,'' he avers. A better way, says Hammer: Outsource only generic tasks, such as tending a data center's mainframe computers and maintaining standard software like that for running payrolls. But retain people who are particularly skilled at applying technology to your business. Some data-processing managers reject outsourcing because they think they can do their computing cheaper themselves. ''If someone else can reduce my cost by 25% to 30% and make a profit, why the hell can't I?'' asks John Hammitt, until recently vice president for information systems at United Technologies. After talking to several outsourcers, he decided that the $22-billion-a-year conglomerate could achieve its own economies of scale; the company plans to consolidate 14 mainframe installations into four. Ray Perry, chief information officer at Avon Products, reached a similar conclusion. By merging six data centers he intends to trim annual costs by $3 million. Says Dan Cavanagh, chief information officer at Metropolitan Life Insurance: ''Those outsourcing guys like big profit margins, which is fine. But if we can be just as efficient as they are -- which I think we can -- the economic benefit will go to us instead.'' The tax advantage of outsourcing, he says, can be captured without letting an outsider run the show; he rents some of his computers from a leasing company. EDS counters that it helps its customers stay competitive technologically, in part by employing scores of industry experts. Says Chief Executive Les Alberthal: ''We recognize fully that the critical thing is to marry industry knowledge to technical knowledge.'' Bonuses for employees on outsourcing accounts are based on how well the customer fares, not EDS; cost reduction is one yardstick. Alberthal leans heavily on the partnership angle: ''I can only be successful if my customers are successful. I've got to do everything humanly possible to make sure the technology brought to bear for them allows them to be competitive.'' ULTIMATELY, outsourcing may point toward a new form of corporate interdependence with implications that extend beyond the computer room. To negotiate its deal with IBM, Kodak used a novel method of consensus building suggested by consultant Elizabeth Gray of Conflict Management and based on a 1981 book called Getting to Yes, by Roger Fisher and William Ury. The two companies made up a long list of points where their interests coincided and where they diverged; Vaughn Hovey, Kodak's director of data center services, says that in the end they were able to accommodate each other unusually well. The result was a joint business plan and a contract only 12 pages long -- hardly the telephone book-size document one might expect. Says Hudson: ''What holds us together is a vision of shared business structures and mutual advantages. The structures we're working toward are more like a biological organism than the old-style militaristic-type organization.'' Michael Treacy, a Cambridge management consultant, compares such alliances with partnerships in other industries. For example, Wal-Mart is electronically connected to Procter & Gamble distribution centers so P&G knows within a day when consumers take Ivory Soap off the shelf. Reordering is automatic. Wal- Mart keeps its shelves fully stocked while holding warehouse inventory to a minimum; P&G gets precise, timely information about buying patterns, which enables it to plan manufacturing and develop new products. Such partnerships, Treacy thinks, are one way American businesses can replicate the mutually advantageous intertwining of companies in Germany or in Japan, where the arrangement is called keiretsu. Says he: ''We're seeing an effort across industries to determine which is the best company to do a given kind of work. You don't want always to be in an adversarial position with your suppliers and customers.'' In his view, outsourcing could serve as part of America's answer to keiretsu.

CHART: NOT AVAILABLE CREDIT: FORTUNE TABLE/SOURCE: YANKEE GROUP CAPTION: THE SEVEN BIGGIES Seven American companies that run computer systems for others account for 56.7% of the worldwide business, which amounted to an estimated $29.6 billion in 1990. Just over half EDS's outsourcing revenue comes from its parent, GM.