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Today, every company has an IT strategy in place, thanks to the proliferation of ERP and the ever increasing sophistication of IT systems. 

Some conglomerates having good bottomlines tend to secure their IT service reliability by spinning off companies which provide IT services to the core businesses. Such spin offs are either owned 100% by the parent or have a promoter holding of the parent. Some notable examples are ITC infotech, L&T infotech and Tech Mahindra, which have evolved into full service IT companies and do not depend exclusively on the parent for their revenues.

On the other hand, there are IT companies whose only source of revenue are the charge backs or internal payments from group companies for the services rendered. To avoid complications of transfer pricing, such companies have fixed hourly rates. Group companies are mandated not to receive IT services from outside, so service companies’ revenues are locked. Their charge back rates are normally higher than the market determined arm’s length prices.

This is a classic example of backward integration where a critical support service is managed from within the group. While the merits of such a setup are many, one of the demerits highlighted by Michael Porter is the ‘dulled incentives’ of the management. In his book, Competitive Strategy, Porter says, “The incentives for the upstream business to perform may be dulled because it sells in-house instead of competing for the business”

Due to the above features, the management of such companies end up managing costs rather than revenues or profits. Because of higher charge back rates and focus on the net profit obviated, they have higher expenditure budgets, which in turn implies more benefits for the managers and employees. Often this results in over hiring, which may result in employees fighting for assignments. Over hiring of managers would imply each manager tries to prove his/her importance and vehemently protect their fiefdoms, resulting in internal rivalry. Knowledge workers, who need food for thought struggle to keep themselves updated and engaged, face the dilemma of making a choice between benefits (that come from high budgets) and intellectual and professional growth (which is stunted since the work quality and quantity is poor).

This results in poor morale of the employees, resulting in high attrition rates. However, high budgets ensures arrogance of the management to get quick replacements, instead of looking into the root cause of the problem. The much desired positive spirit is lost and everyone is frustrated.

The way out of this is to either follow good transfer pricing practices (like negotiation between the IT service provider and the consuming company) or by allowing the IT service company to venture into the market to gain business and satisfy its shareholder(s) (termed as tapered integration by Porter). This will ensure that the service company’s hurdle rate is referred to while making any investment. Professional companies named above do the same, and are in a better position than the ones who do not.

I wonder how Porter knew in 1980 the issues which managers are facing today.