To re-examine the economics of outsourcing, I collected 2002 payroll data on a diverse and random sample of 324 companies listed in Standard & Poor's financial reports. After adding taxes, profits and depreciation, I calculated each company's value-added. The difference between sales and the value-added yielded the worth of outsourced purchases because sales minus value-added equals the amount that has been outsourced to suppliers.

The results were surprising. One hundred and seven companies reported a negative return on shareholder equity, which would mark them as losers. But 217 reported a positive return on shareholder equity, which would earn them the winner's label. There were, however, statistically significant differences between the losers and the winners.

The losers' average outsourcing-to-sales ratio was 25% greater than the winners'. Eighty-six percent of the losers were outsourcing more than half of their costs. The returns on shareholder equity for the winners were clustered around low outsourcing ratios; the large losers showed high outsourcing ratios.

To verify these insights, I ran an analysis of 466 U.S. banks. For this homogeneous sample, the negative relationship between outsourcing and profitability was statistically even more significant. What do these finding tell us?

1. My 1995 assertion that "outsourcing is a game for losers" still stood up in 2002, even though in this case I don't propose to connect the outsourcing of IT with negative profitability. The current findings offer a managerial perspective on the economics of outsourcing.
2. My calculations indicate that only 26% of the low profitability results are attributable to outsourcing. Companies already failing for other reasons will tend to outsource increasing amounts of work, thus diminishing their value-added.
3. My findings don't support the frequent predictions that U.S. firms will tend to outsource in order to increase profits and thus eventually leave us with a "hollow" economy.

First, the decision to outsource IT shouldn't be taken in isolation and without full exploration of the potential effects on the overall financial performance of a company. Sure, one can always show savings by passing IT tasks to someone who can do it cheaper. But IT accounts for only a small share of the total costs that a company incurs. The damage from mismanaged outsourcing will always exceed the potential benefits from anticipated IT cost reductions.

Second, any company bidding on an outsourcing contract should ascertain whether the potential client is a loser or a winner. There are many cases that demonstrate why delivering services to losers with already damaged systems is risky. Whenever IT work is outsourced, even under an ironclad contract, there is the likelihood that the losers' damaged operations systems can't be fixed by handing over custody for critical applications to a contractor. Both the winner of such an outsourcing contract and the company doing the outsourcing will end up worse off and in hard-to-reconcile finger-pointing.

Paul A. Strassmann (paul@strassmann.com) was involved in one of the largest IT outsourcing contracts ever made and witnessed how everyone ended up a loser.