Opportunity Cost vs. TCO in IT Outsourcing: An Example from British Airways
The Notion of Opportunity Cost
Opportunity cost is a fundamental economic concept representing the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. In simpler terms, it's the value of the best alternative foregone.For instance, if a company decides to invest in a particular project, the opportunity cost is the value of what could have been achieved if those resources had been invested elsewhere. In procurement, failing to consider opportunity cost can lead to suboptimal decisions, as it neglects the potential gains that could have been realized through alternative investments or choices.
IT Outsourcing at British Airways (research-based assumptions)
In 2016, British Airways outsourced its UK-based IT staff as part of its business strategy.This outsourcing strategy allegedly resulted in a 2017 global flight disruption that affected 75,000 passengers and caused nearly a 150-million-pound loss.
Previously, BA claimed a 25% reduction in its IT operational costs. However, due to some simple considerations, I'm unsure if the risk exposure has been accounted for in the business case.
A typical large company's IT budget (over $1 billion in revenues) is 2% of revenues, translating into approximately £210 million for BA in 2016. Let's assume 50% of that is related to infrastructure operations, maintenance, support, security, etc. A 25% saving corresponds to just £27.5 million vs. the single 2017 crisis cost of £150 million.
Otherwise, let's assume a business case as follows.
TCO Calculation for In-house IT Operations:
Initial Costs:
• Hardware and Infrastructure: £50 million
• Software Licenses: £30 million
• Implementation and Setup: £20 million
Recurring Annual Costs:
• Personnel (Salaries, Benefits, Training): £60 million
• Maintenance and Support: £25 million
• Utilities and Overheads: £10 million
• Tools: £5 million
Lifecycle Costs Over 5 Years:
• Initial Costs: £100 million
• Recurring Costs: (£60 million + £25 million + £10 million + £5 million) * 5 = £500 million
• Total in-house TCO: £100 million + £500 million = £600 million.
Outsourced IT Operations
Initial Costs:
• Transition and Setup Fees: £50 million
Recurring Annual Costs:
• Outsourcing Contract Fees: £75 million
• Additional Services and Upgrades: £5 million
Lifecycle Costs Over 5 Years:
• Initial Costs: £50 million
• Recurring Costs: (£75 million + £5 million) * 5 = £400 million
• Total Outsourced TCO: £50 million + £400 million = £450 million or £150 million saving vs. in-house.
Opportunity cost as a revenue
The average revenue per employee in the airline industry in 2016 was £350,000. Can we assume an opportunity cost of £245 million per year (700 * £350,000) as a strong argument in favor of the in-house scenario? Actually, we're talking £1,225 billion over five years.
Let's just recall that one dollar of savings doesn't equal one dollar of revenue from the P&L perspective, especially for an industry with a low profit margin, such as airlines (5.1% profit margin in 2016).
ChatGPT on revenue vs. savings in the airline industry
Let's now ask ChatGPT: "How many dollars in revenue equals one dollar in savings when the profit margin is 5,1%?"
The answer is: "So when the profit margin is 5.1%, it takes approximately $19.61 in revenue to equal one dollar in savings. This means for every dollar saved, the company avoids the need to generate around $19.61 in additional revenue to achieve the same increase in profit."
Therefore, let's finalize our opportunity cost calculations by dividing £1,225 billion by 19.61, £62.5 million. We must compare this with the earlier calculated savings of £150 million over five years.
Perhaps the opportunity cost of £62.5 million would not reverse the decision to outsource, given the £150 million savings. However, until we recall the £150 million disruption cost in 2017, the opportunity cost may become the decisive factor.
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