Adjusting Outsourcing Relationships to a New Economic Reality

Today, many businesses worry more about survival than about gaining a competitive edge. As a result, cost reduction, commodity services, and efficiency have in many cases replaced strategic investment and new initiatives as top client priorities. Outsourcers originally charged with shepherding business expansion must now retrench. As a result, many players today seek to make the best of a bad situation. How best to proceed? Specifically, how can damaged relationships be repaired? And how can existing outsourcing contracts signed during the halcyon days of the late 1990s be renegotiated and restructured to meet today’s new requirements? This article draws upon over a decade of research and advisory work carried out to examine these questions and other issues related to outsourcing management.

Avoiding Temptation
Ideally, a contract renegotiation is a mutually beneficial dialogue that ensures alignment of services with business goals, and identifies new opportunities to add value to the relationship. Such discussions are conducted on a routine basis, as part and parcel of the ongoing governance process. More often, of course, one of the two parties comes to the table with a grievance. In some cases, the vendor is unhappy with a low profit margin and seeks an adjustment to terms. In others, the client feels the services delivered do not warrant the fees being paid. In these situations, whichever side enjoys the contractual advantage should avoid the temptation to press it too strongly. The idea that clients should “squeeze” struggling suppliers on cost is short-sighted and counterproductive. Similarly, outsourcers should be wary of deals tilted too sharply in their favor: In almost all large-scale outsourcing engagements, working things out is preferable to scrapping the relationship. Vendors can scarcely afford to lose major clients, while for clients the cost of switching vendors halfway through a deal is prohibitive.

The Profit Motive
Allowing the vendor to earn a reasonable profit is essential to the long-term success of an outsourcing relationship. The incentive of profit – and of additional reward for outstanding work – motivates a vendor to commit resources and key talent to improve service levels, identify new opportunities, and address the client’s business problems. Contracts focused exclusively on cost reduction will inevitably encourage a status quo mentality, in which the outsourcers delivers services to the bare minimum necessary to justify the monthly invoice. The common practice of “back loading” contracts has complicated the role of profit in outsourcing relationships. Back loading refers to the practice of structuring the deal to deliver unsustainably low margins in the early years (so as to attract the client into the relationship), and then compensating with higher margins towards the end of the contract term. The problem for many client organizations today is that they are entering into the high-margin back end of their contract terms, precisely at a time when economic circumstances dictate cost reduction.One approach to addressing this problem is to negotiate the

One approach to addressing this problem is to negotiate the in sourcing of various functions handled by the vendor. If some low-margin services can be brought back in-house, the outcome can potentially be mutually beneficial. Other options could include bringing in an offshore outsourcer to reduce costs, or implementing technology upgrades that are stipulated but haven’t been completed.

Benchmark Clauses
Exercising the benchmarking clause in an existing outsourcing contract often provides the best opportunity to baseline existing services, repair a damaged relationship, and adjust terms to new conditions. Compass recently analyzed 72 outsourcing contracts for IT services in North America, Europe, and Australia in which a benchmark clause was exercised. The initiatives were successful in 68 percent of the cases, in that both parties accepted the outcome of the benchmark review and contract terms were adjusted. In the 32 percent of instances where the review was unsuccessful, the initiative was either cancelled or the client changed vendors. Compass observed a wide degree of variance between vendors in completing benchmark review initiatives. Specifically, major outsourcing vendors with mature global capabilities were more successful; in the contracts analyzed, these players completed and implemented between 80 percent to 100 percent of benchmark reviews they were involved in. Several smaller vendors with a local or national focus, meanwhile, completed 0 percent of the initiatives they were involved in. An objective third party is often essential to ensuring the success of a benchmark review. Ideally, by identifying and quantifying the specific elements of service delivery that need to be re calibrated, the third party facilitator can enable both sides to buy into the process sufficiently to develop an equitable solution. For the outsourcer, exercising an effective benchmarking clause steadies the target by establishing objective, fact-based performance criteria. By validating the price and quality of outsourced services and facilitating a successful resulting negotiation, a benchmark review can enhance client/vendor cooperation and communication and help to build trust. Another point favoring a benchmark clause is the underlying premise that dissatisfied clients are not good for the outsourcing business. The service provider’s interests are clearly served through an ongoing relationship, whereby contracts are renewed and new areas of opportunity revealed. Using the benchmark process to find new solutions to existing problems therefore provides an advantage to the vendor.

Inadequate Retained Function
Client requirements to manage the outsourcing vendor are typically one of the most neglected areas of outsourcing governance. Client organizations either devote too few resources to managing the vendor, or the people who are put in charge of the relationship lack the skills, training, or inclination to make the relationship succeed. An analysis of over 300 outsourcing contracts conducted by the Warwick Business School in the United Kingdom found that internal management accounts for between 4 percent and 8 percent of the overall cost of outsourcing; for offshore outsourcing arrangements signed in the lead up to Y2K, management accounted for 12 percent of total cost. Some offshore deals with higher management costs have subsequently been observed. The surprisingly high cost of internal management is rarely factored into the cost savings analysis done at the deal’s outset. In the context of today’s economic climate, this unanticipated cost becomes especially onerous if the client organization views outsourcing primarily as an opportunity to reduce costs and cut headcount. The tendency to draw the internal management team from the existing internal IT group is also problematic. IT practitioners from the client organization – while perhaps technically skilled – may lack the business experience needed to effectively manage the vendor. The client team is tempted to re-create islands of IT activity, duplicating the work done by the service provider. Ironically, then, the outsourcing initiative designed to take a more “strategic” approach to IT management becomes more tactically oriented than the model it replaced.

Nine Capabilities
The Warwick Business School researchers identified nine core IT capabilities client organizations should maintain within their internal organization.1 Some of these capabilities are business focused – specifically, Relationship Building and Business Systems Thinking. Technical Architecting and Technology Fixing, on the other hand, are technology-oriented. Four capabilities ensure external supply is managed and leveraged: Informed Buying; Contract Monitoring; Contract Facilitation; and Vendor development. Leadership ensures the coordination, staffing and governance of these three groupings and works on developing the role holders into a high performance team. We are now very clear, having worked with many major corporations on their management issues, that these nine in-house capabilities represent the minimum needed to run large-scale outsourcing deals. Surprisingly often, however, we find several of these capabilities missing even four years into outsourcing arrangements.

The Top Ten List
If an outsourcing relationship is damaged, one potential strategy is for the client organization to define the top ten issues of concern that need to be resolved. This requires a substantial amount of due diligence to establish that the concerns are based on facts and can be documented. The top ten issues are then reviewed with the vendor, item by item, to determine whether the concerns are valid from the vendor’s perspective. Once both parties agree on the nature and extent of the ten issues, the vendor is given a period of time to develop a solution to each of the issues. The client’s responsibility is then to establish monitoring mechanisms to ensure that the vendor actions agreed to for each of the ten issues are actually implemented. The process can, of course, be carried out in reverse, with the outsourcer identifying a list of ten items of contention that should be addressed to improve the relationship. In either case, however, the task requires a high level of management commitment to implement the metrics, mechanisms, and processes necessary to ensure that what’s agreed to is done.

Fresh Faces
The existence of ill will on one or both sides of the table presents a major challenge to a successful renegotiation. In some cases, both sides might be well-advised to replace the team members involved in service delivery and management. This allows a fresh perspective and improves the likelihood of progress. Generally speaking, vendors tend to be more willing to replace their team rosters than are client organizations. Regardless of the players involved, objective criteria and mechanisms are essential. Absent objective facts that both sides can accept, the discussion will almost inevitably become emotional and counterproductive.

Balanced Scorecards
Work is ongoing with several outsourcers to adapt traditional balanced scorecards to use as tools to evaluate performance and enable a discussion of value contribution beyond cost reduction and efficient delivery of commodity services. By using added value as one of the scorecard perspectives, the model provides the vendor an opportunity to identify value provided over the course of the deal, and to define linkages between business needs and services delivered. And if the vendor can demonstrate a value contribution, then the scrutiny of cost becomes less intense. If the existing relationship has been seriously strained, however, the discussion will likely revert to hard numbers and a narrow financial argument. That said, in at least one instance where the relationship between a bank and its IT supplier had become damaged, the balanced scorecard concept succeeded in clarifying goals and defining mutual ways forward.

The Third Corner
An imaginative approach to problem resolution can be the key to success in outsourcing renegotiations. If both sides are entrenched in their positions – or stuck in their respective “corners” – the discussion becomes a win/lose proposition. The loser, in other words, has to move, grudgingly, to the winner’s corner. This model may work in the short term, if, say, the client has more bargaining power, or if the vendor is desperate to win an additional piece of business. A more effective long-term solution, however, can be for both sides to seek a completely different approach – a “third corner” – that is attractive to both sides.

 

Summary and Conclusions

  • A reasonable profit margin for the outsourcing vendor is essential to the long-term success of an outsourcing relationship. Neither side can sustain an unrealistic cost advantage.
  • Benchmark clauses can be an effective tool to reassessing and adjusting contract terms.
  • An objective, fact-based approach is essential to the benchmarking process; specifically, to identifying the service and performance issues involved. Involvement of a third party is essential.
  • Client organizations tend to minimize the internal management resources required to effectively manage an outsourcer. This often results in dysfunctional outsourcing relationships.
  • Changing the client and vendor team members involved in management and service delivery can often help repair strains in a relationship.
  • The balanced scorecard model can be an effective tool for an outsourcer to demonstrate value delivered to the client organization.