What You Should Know about Outsourcing Contracts

The evidence continues to mount that outsourcing is much more complicated than people realize.

According to one recent survey of leading global businesses conducted by Deloitte Consulting, “Instead of simplifying operations, outsourcing often introduces complexity, increased cost, and friction into the value chain, requiring more senior management attention and deeper management skills than anticipated.”

The dynamics of outsourcing are such that unpleasant surprises, unanticipated costs, and contentious issues tend to emerge several years into the relationship. While these problems underscore the need for better ongoing management by the client organization, their roots can often be traced to the early stages of negotiations.

By understanding the problems that afflict outsourcing relationships, client organizations can effectively address them when they ariseor, better still, avoid them in the first place.

Back-end loading

Negotiation strategies employed by vendors represent one set of challenges. A common negotiating tactic is “back-end loading,” where the vendor accepts a break-even or loss situation at the beginning of a contract (usually the first 18 months), and recovers those losses during the latter stages of the deal. Compass analyses indicate that back-end loading accounts for the savings in the majority of cases in which outsourcing reduces costs during the first year.

The back-end approach to pricing is perfectly legitimate, as long as the client organization is aware and agreeable. In some instances, clients agree to this pricing approach. If they need an immediate, substantial cost saving, a business can be quite willing to essentially borrow from the vendor and pay back the “loan” in the latter part of the term. In other cases, clients are not aware of the financial structure of the contract, and outsource with the intent of achieving cost savings throughout the life of the contract.

Buying the business

In certain markets, vendors may be willing to suffer a loss on a particular client in order to increase market share, or to gain a foot-hold in a specific geographic or vertical segment. Some organizations have benefited from this strategy, but others have discovered that it is not viable in the long term. Whatever good intentions the vendor negotiation team has at the outset, a deal resulting in a consistent annual loss is not acceptable to the vendor. Client organizations in this situation often complain that vendors become obsessed with either trying to sell additional services, or overcharging for out-of-scope services that the client believed were in the original contract. Another complaint concerns the absence of “hot skills” and poor staffing levelsa reflection of a vendor’s reluctance to invest resources in a losing proposition. The lesson: for a client to command a vendor’s attention and commitment, the deal must be profitable for the vendor.

Cultural misalignment

A more general issueand one that is frequently overlooked when clients evaluate vendor capabilitiesis the element of cultural fit. While the concept may seem vague and tangential, a bad cultural fit can be disastrous. For example, a fast-moving and dynamic organization may be frustrated by a vendor guided by structure and hierarchy. One benefit of the RFP and evaluation process is to provide the client needed time to get to know vendor staff and understand the culture and values of the vendor organization.

Big is not always better

Clients should not assume that a large outsourcer is more qualified. In fact, the opposite might be true. A relatively small client organization may have very little leverage with a large vendor. Also, a client based predominantly in one geographic region may not be a good fit for a large, global outsourcer. The most successful outsourcing deals Compass has analyzed involve a client and vendor of similar size operating in one geographic regiona situation that facilitates cultural understanding and equality.

The benchmark clause

The most effective way to manage outsourcing costs and quality is through a contractual benchmarking clause which mandates periodic evaluations of pricing and service quality against industry standards. Given the importance of this clause, surprisingly little attention is devoted to its drafting and negotiating at the outset of a relationship. Benchmarking should be performed by an independent third party at regular intervals (every one to two years) on all service towers. Clients should seek professional advice in drafting the clause, to ensure that it clearly defines the process to be followed, that access to data is guaranteed, and that the outcomes will be acted upon. An effective benchmarking clause includes a governance review that extends beyond purely financial and service issues to take a more holistic approach to the outsourcing relationship.

There’s no denying that outsourcing in large organizations is a complex situation that requires careful management and oversight. It’s also true that implementing some basic mechanisms of governance at the outset of the agreement can help ensure accountability and alignment over the long term.

Geraldine Fox is Global Leader for Compass’ Sourcing Service Line. She is based in Victoria, British Columbia.