Since the late 1980’s, outsourcing vendors have relied on subcontractors to perform part of the work required in outsourcing relationships. Although customers often assumed that the functions subcontracted were non-critical services,† a number of trade press articles a few years ago revealed that the outsourced functions included some that any client would view as potentially at the heart of the relationship.
A concurrent development within the industry was a move toward “selective” outsourcing of certain IT functions to obtain the best-of-class vendors for the chosen functions. Analysts were somewhat vague as to how multiple vendors should be managed, but the often unstated assumption was that this coordination role was strategic and should be retained by the customer.
These trends not only set the stage for today’s multi-vendor environment, they also raise a number of important issues that should be considered by any customer contemplating establishing such an outsourcing relationship.
The Sourcing Spectrum
All sourcing decisions involve consideration of three-related functions: procurement method, delivery approach and management model. The customer can choose from a spectrum of options to ‘procure’ or purchase goods and services to satisfy a particular corporate need.† Three key options are:
- In-house delivery, in which the vendor provides goods and/or services, but company employees bear primary responsibility for the function.
- Contracting out, in which responsibility for success of the function is shared between company employees and the vendor.
- Outsourcing, in which the vendor is delegated responsibility for performing in an end-to-end fashion a readily identifiable service.
A customer’s corporate culture and sourcing objectives dictate the sourcing approach to be followed. Oftentimes IT goods and services are provided through a combination of all three options. The key point is to understand which approach is being followed for each good or service being procured and to adopt a delivery approach management model consistent with that approach.
The Role of Subcontracting
Regardless of the sourcing option chosen, subcontracting likely will play some role in how goods and services are delivered. What exactly is subcontracting? It is best defined as the delegation of significant responsibility for the end-result delivery of a meaningful service to a third party. This differs from mundane “purchase order” procurements, such as heat and power. Even with this definition, there is some fuzziness. For example, is the use of body-shop contractors to provide resources for applications maintenance subcontracting? The answer may vary, depending on the scope of the activity.
For work described as a purchase order, the outsource vendor should be free to make appropriate decisions without customer review so long as the vendor accepts responsibility for the purchase decision and is ultimately responsible for delivery of the service. One might make a comparable argument about subcontracting. However, the better approach would be to characterize the outsourcing relationship as a “personal services” contract and require some level of customer review and approval before any subcontract is let. The outsource vendor should take absolute responsibility for the work of the subcontractor, all subcontracted functions should be disclosed and certain minimum information about the subcontractor be provided to the customer. Moreover, the customer should have both a right to “bar”; any subcontractor from providing goods or services to the company, consistent with the company’s general procurement practices, and a reasonable right to have non-performing subcontractors replaced.
Contracting with Multiple Vendors
How do multi-vendor outsourcing arrangements differ from subcontracting. That question must be considered from both the contractual and relationship structure viewpoints.
Contractual structures. Multi-vendor outsourcing transactions have been structured either as a single prime contract, with well-defined multiple subcontracts, or as a set of separate contracts and some form of “operational” agreement among all the vendor participants and the customer. The first structure is a true subcontracting relationship, but with a significant twist. Rather than have the outsource vendor take sole responsibility for identifying what goods and services might be subcontracted and with whom, the customer structures various combinations of suppliers for identified scopes of service. Interestingly, this adds a new requirement not usually viewed as part of subcontracting. Now, the customer not only wants pre-review and approval with respect to subcontracts, but also the right to insist that the prime contractor not remove or reduce the scope of any of the subcontractors that were put together as part of the initial team.
Based on experience with each form of structuring, our firm strongly recommends the prime-subcontract model rather than the multiple contract model. This structure establishes a single point of responsibility for the entire relationship and eliminates constant “finger pointing” among the suppliers. It also places the responsibility for missed or overlapping services on the vendor team where it belongs.
A prime contract also makes the legal issues of limitations of liability, indemnity and warranty easier since responsibility for these matters need not be divided up among multiple parties. It also enhances the efficiency of the general contracting process, since only one set of basic terms need be negotiated.There are some perceived negatives about the prime-subcontract model, including the following:
- The prime contractor will impose some markup on the fees charged by its subcontractors. We believe the customer should regard reasonable markups as payment for significant benefits from the prime-sub relationship.
- The customer loses the ability to deal directly with the subcontractors. In truth, the customer should retain the right to deal with subcontractors on day-to-day operational issues, and the subcontractors should also be directly involved with the customer on planning and strategic issues. All that is “removed” from the relationship is dealing with the subcontractor on contractual issues.
- There may be more difficulty in developing an “exit strategy” with a prime contract since the customer does not have the ability to easily replace parts of the relationship. Again, this view represents some misconception about the structure. Customers should negotiate partial rights of termination regardless of whether there is a single prime contract or multiple vendor contracts.
Relationship structure. A customer’s ability to manage the multi-vendor outsourcing transaction depends most directly on how that relationship has been structured. In a multiple contract structure, none of the vendors is responsible for the others’ performance. Thus, even though the relationship may be structured and viewed as an outsourcing arrangement, the customer must adopt a strong contract administration function that deals with the various tensions and issues that are likely to arise among the vendors. Accordingly, the customer should be prepared to assume an active role in monitoring and controlling intra-vendor issues.
By contrast, with the prime-subcontractor model, tensions and disputes among the vendors are resolved at the prime contractor-subcontractor level, where the customer may not have direct participation. It would, however, be a significant problem if the customer ignored such potential tensions and either assumed they did not occur or delegated them entirely to the prime contractor to resolve. Two key elements in the success of any multi-vendor outsourcing relationship structure using a prime-sub model is the ability of the customer to have useful insight into, and intelligence about, potential vendor disagreements, and the informed exercise by the customer of its involvement in, and resolution of, such disagreements. In order to successfully address these two requirements the prime contract needs to include provisions requiring the prime contractor to report to the customer on disputes with the various subcontractors and authorizing the customer to participate in meetings with the prime and subcontractors to resolve such issues.
To manage multi-vendor outsourcing relationships successfully, customers should focus on three main issues: (1) adopting the correct sourcing strategy given the particular objectives sought by the customer, (2) using the right form of contract which we recommend be a prime-sub relationship, and (3) staying attuned to potential intra-vendor issues so that the customer can properly protect its interests at the appropriate time and in the right manner.
Robert E. Zahler is a partner in the 280-person law firm of Shaw, Pittman, Potts & Trowbridge. The firm has represented numerous outsourcing customers in some of the most high-profile outsourcing transactions within the industry.
Lessons from the Outsourcing Primer
- Customers can choose from a spectrum of options for procurement of goods and services.
- Management of a multi-vendor relationship should match the option chosen.
- Multi-vendor relationships can be structured as single prime contracts with subcontracts or as multiple subcontracts.
- A prime contract offers many advantages.