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.

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.

Finally, many benchmark clauses set financial performance targets unrealistically and unfairly high. While clients should expect an outsourcer to aim for price and performance standards that are the average of world-class organizations, in many cases benchmark clauses stipulate that the vendor must match the top 10 percent of industry performers within each category. This is analogous to asking a track athlete to compete in the 100-meter dash as well as the marathon. A client might argue that the outsourcer agreed to these high standards in the first place and is therefore responsible for delivering. However, neither party benefits if the outsourcer is unprofitable, and both client and vendor should ensure that the financial standards are fair and achievable.

One common strategy outsourcers employ to avoid the benchmarking process is to offer an upfront discount if the client agrees not to execute the clause. From the vendor’s perspective, ceding a known quantity of revenue is preferable to the risk and uncertainty of a benchmark review that could result in a much larger liability. For the client organization, a discount is often appealing, since the investment in time and management attention can be avoided.

In other cases, vendors seek to undermine the entire benchmarking process by insisting on restrictive conditions that limit the effectiveness of the initiative, resulting in clauses that are difficult or impossible to execute.

What Clients Should Do

The client organization must recognize the importance of benchmarking to managing the relationship and focus on negotiating an executable benchmarking clause that will not restrict them in the future.

Client organizations should avoid the temptation to accept an outsourcer’s offer for a price discount in lieu of an outsourcing evaluation. For one thing, the benchmark exercise can reveal serious problems that, if neglected, undermine the viability of the long-term relationship. Moreover, an effective benchmark involves more than simple price comparisons and should be a strategic opportunity to improve performance and the sourcing partnership.

Clients can address specific vendor objections to benchmarking evaluations in a straightforward manner. For example, a back-end loaded contract should be benchmarked with the long-term pricing implications taken into account. Moreover, a client who is underpaying for services should consider bringing charges in line with prevailing pricing, as this could benefit vendor commitment and service quality and enhance the long-term relationship. Finally, clients should temper an aggressive approach to improvement with a realistic assessment of what can be achieved.

Elements of a Successful Benchmarking Initiative

A successful benchmarking initiative is characterized by the following four criteria:

Database or Reference Group: The client organization’s performance must be analyzed in an apples-to-apples context. Specifically, the organizations the client is compared against should be reasonably similar or at least comparable in terms of size, scope, geographic distribution, and other factors.

Adjustments: Even when the organizations comprising the comparative reference group are very similar to the client organization, some normalization of scope, quality, and pricing of services will be required. These adjustment calculations can be based either on prices extracted from existing outsourcing contracts, or on costs incurred by internally managed organizations.

Transparency: Both the vendor and client organization should have access to information regarding the reference group and the nature of any adjustments. Specifically, all parties must have a clear understanding of how pricing targets are defined, what goes into the calculation of those prices, and if and how adjustments are made. However, since both parties must be willing to accept the benchmarker’s need to protect client confidentiality, transparency has limits.

Profit Motive: Pricing targets should be based on fair market value, and not be readjusted to reflect a particular vendor’s cost of delivery. This means that a vendor who can deliver services for significantly less than prevailing market rates should reap the benefits. For example, if $10 per call constitutes a fair market price for Help Desk services, then a client should agree to pay that rate even if a vendor is able to deliver services for $5 per call. This type of stipulation is essential to motivate vendors to support benchmarking initiatives and to invest in innovation.

Benchmarker leads the process: To execute a fair and effective benchmark, both parties much accept the guidance and leadership of the benchmarker.

Benchmark as Win/Win

Many outsourcing relationships falter because the parties’ original intent of forging a value-based strategic alliance falls prey to the nitty-gritty of negotiating the contract’s final terms. A periodic contract evaluation and benchmark review can be an effective way to revisit and re-introduce strategic elements into the relationship.

Some basic rules govern the success of such an engagement. The process should be constructive and strategic in nature, and both parties must conduct themselves with a view to building the relationship over the long term.

In this context, the benchmark exercise becomes a full governance review a strategic exercise that examines how best value can be delivered and competitiveness maintained, that identifies new opportunities for the vendor in terms of additional services to offer, and that takes into account the unique characteristics of the relationship structure.

Geraldine Fox is Global Leader for Compass’ Sourcing Service Line.