The recession is pushing businesses to cut the cost of their software portfolios, but most companies overestimate the savings that offshoring can deliver, according to Compass Management Consulting.

Companies rushing to outsource their software development for quick savings actually risk significant losses in productivity because developers do not fully understand business requirements, according to the consultants.

While staff costs may be 40 per cent lower in offshore locations, Compass research found these savings were undermined by a 60 per cent drop in productivity in operations where the full lifecycle of application development has been outsourced.

"This means that the decision to migrate development, when you include additional management control, increased infrastructure spend, employee attrition, language, and cultural issues, can end up costing up to 20 per cent more than current in-house operations," said the consultant group.

Compass analysed over 200 outsourcing contracts, accounting for a total value of more than £3bn over the past two years.

Many organisations are already replacing legacy systems and updating applications to reduce costs, said Nigel Hughes, a consultant at Compass. "Complexity of the application environment is a major driver of overall cost escalation in IT, and 2009 is the best chance since the year 2000 issue to make radical change."

Staff attrition related to moving application development to offshore locations, particularly the loss of functional expertise, will have having a "negative effect" on productivity.

"With lower productivity in many offshore locations and currency movements that are working against UK buyers, it is important to outsource the right type of development project and ensure that business analysis skills are kept in-house in order to make any savings," said Hughes.

"More than 70 per cent of a typical software budget is spent on maintaining legacy systems. Top performers are clear that they cannot run a 21st century operation supported by 20th century technology," said Hughes.

But Compass said that rationalising software estates by consolidating applications could reduce spend by 20 to 40 per cent within less than a year.

Compass advised companies to keep strategic applications in-house, and look at outsourcing "non-strategic, non-critical and low complexity applications".

"For the strategic, complex and business critical applications, it makes more sense to retain the analysis skills that will drive the innovation and value in-house," said Hughes.

Lancashire County Council used Compass to assess whether it should outsource its IT services or keep them in-house. Compass and Socitm both reported to Lancashire that its own services were more efficient than outsourcing.