The cover-story of this week’s issue of BusinessWeek sings the praises of the rapidly expanding outsourcing business. The article points out that corporations of all sizes are leveraging services from a myriad of providers in India, China, Eastern Europe and beyond to satisfy nearly every aspect of their R&D, manufacturing, distribution and support needs.

Yet, today’s outsourcing business hasn’t been kind to many of the traditional industry leaders. IBM announced on 1/17/06 that its Global Services division had another disappointing quarter because of rising competition in its core outsourcing business. Even one of its primary offshore competitors, Wipro, reported on the same day that it was having trouble matching the margins of its India-based peers despite a 25% rise in its fiscal 3rd quarter net profits.

Given these discouraging financial results, it is not surprising that the deal to sell Affiliated Computer Services (ACS) to a consortium of private equity firms also collapsed this week.

What’s the problem?

The most obvious answer is the escalating competition which is pinching profits by forcing outsourcers to rapidly expand their global operations while at the same time withstand intensifying pricing pressure. But, there is an even more subtle problem with the fundamental structure of today’s outsourcing business that the business or trade pubs have mentioned, but haven’t fully assessed. This is the downsizing of outsourcing contracts.

Even as the size of the outsourcing market grows and nearly every corporation is outsourcing a greater proportion of their operations to third-parties, the size of outsourcing contracts has been dropping for the past two years according to nearly every major market research firm.

Why is this happening?

The track record of success for outsourcing has never been great. In the IT industry, at least half of today’s outsourcing deals will fail to meet their original business objectives according to Gartner. As a result, these deals will either be terminated or substantially restructured.

In order to mitigate the risks associated with a failed outsourcing arrangement, corporations are reducing the scope and lifespan of their outsourcing agreements. They are also relying on multiple providers to perform a variety of more specific tasks, rather than be dependent on a single outsourcer to do everything. This is a trend that I began calling “out-tasking” over ten years ago, and it is still the most common method used to leverage third-party service providers.

This trend is also fueling the growth of more focused managed services and software-as-a-service (SaaS). These solutions address specific IT and business requirements, and use shorter term subscription-based fees. THINKstrategies’ research has shown rapid adoption of both managed services and SaaS as enterprises of all sizes become comfortable with these outsourcing alternatives.

Interestingly, none of the major outsourcers has been able to restructure their existing business models to capitalize on the rise of managed service and SaaS. The outsourcers have either overlooked the significance of managed services and SaaS, or they have been unable to convert their traditional people-intensive outsourcing sales and service engines into effective platforms for selling and delivering more automated and targeted managed services and SaaS solutions.

Until they figure out how to add managed services and SaaS to their portfolios, traditional outsourcers like IBM and offshore players like Wipro are going to face rising costs and increasing price competition in their primary service businesses.