Dos and Don'ts of Outsourcing Benchmarks

IT and finance executives face increasing pressure to ensure that outsourcers deliver quality services at competitive prices. The specific challenge is to determine whether particular sourcing arrangement is good or bad in the context of rapidly changing market conditions.

By Geraldine Fox

March 30, 2006 — CSO —

IT and finance executives face increasing pressure to ensure that outsourcers deliver quality services at competitive prices. The specific challenge is to determine whether particular sourcing arrangement is good or bad in the context of rapidly changing market conditions.

Benchmarking clauses to outsourcing contracts can help address this challenge. Such clauses are executed periodically throughout the contract term to provide ongoing value verification by evaluating whether services are being delivered for a fair market price and at the appropriate level of service quality. Benchmark analyses can provide a much-needed point of reference in a rapidly changing environment, and help address the need for enhanced fiscal responsibility and accuracy in corporate reporting.

Despite these potential benefits to client organizations, outsourcers are often ⬠and sometimes with good reason ⬠reluctant to execute benchmarking clauses. By recognizing and addressing these concerns, client organizations and vendors can work together to implement a benchmarking process that benefits both parties and contributes to a successful long-term relationship.

Why Outsourcers Don't Like Benchmarks

The primary reason outsourcers dislike benchmarking is because the analyses show that, for large well-run organizations, outsourcing is almost always more expensive than keeping the services in-house.

While Compass has observed up-and-coming tier 2 and 3 vendors offer aggressive pricing, substantial cost saving potential still exists in the global mega-deals, particularly those that are over three years old. Compass benchmarks of these contracts have found that pricing can be 15 percent to 25 percent greater than the current market price, and an astonishing 30 percent to 40 percent greater than top-performing in-house operations of similar size and complexity. What accounts for the high prices, and are the vendors at fault?

The answer is complex. During contract negotiations, many companies focus on short-term cost savings, and pay a premium later in the contract term. Compass has witnessed savings of 18 percent (10 percent ⬠15 percent is more typical) in year one of a contract turn into unit costs 23 percent above market rate by year 2. By contract term the gap to market rate can be in excess of 50 percent.

• This negotiation strategy ⬠called "back-end loading" ⬠means that the vendor accepts a break-even or loss at the beginning of a contract (usually the first 18 months), and expects to recover those losses during the latter stages of the deal. In this context, a vendor's reluctance to execute a benchmark is understandable. Specifically, a benchmark executed towards the latter part of the contract term can adversely affect the "sweet spot" of the deal for the vendor. While a benchmark may indicate that the vendor is making a substantial profit at a particular time late in the contract term, a long-term perspective that considers the entire life of the contract shows that the vendor is simply recouping the losses made in the early years of the contract.
• Another problem with benchmarks is that, from the vendor's perspective, they generally represent a lose/lose proposition. Specifically, benchmark results are often non-negotiable, and vendors have no recourse to challenge or rebut the findings. Equally onerous is the fact that benchmark findings generally apply only to the vendor. In other words, if a client pays too much for services, then the vendor must provide compensation. However, if a benchmark reveals that a client is paying below market rates, then there's generally no mechanism in place to raise prices to a more equitable level.

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