The Long and the Short of it All | Article

Arms Pulling ropeThe industry is abuzz about the need to make outsourcing deals more flexible. All parties agree that flexibility is desirable if it can be achieved fairly. But there is a variance in opinions among buyers, suppliers, legal analysts and consultants as to how to accomplish it. Can flexibility be built into a contract? How can both parties ensure that flexibility will be the tool used to maintain the deal over the long term? Are smaller deals more effective in eliminating flexibility problems than mega deals? Are there risks involved in becoming too flexible?

InfoServer has studied the problems surrounding flexibility — how to build it, keep it, and how it affects the pursuit of excellence in the outsourcing industry. This month we present perspectives and highlight suggestions from world-class companies who have met with success in their efforts to provide for flexibility over long-term relationships.

The problem of lack of flexibility is not necessarily due to a lack of planning or foresight on the part of outsourcers. We at InfoServer believe the characteristic of inflexibility is inherent in the basic structure of the outsourcing industry.

The other thing a buyer needs to do is to add incentives (or restructure the original ones) that will realign the supplier’s interest and motivation as the objectives change over time. A buyer does not want to get into a contract with an unnecessary long duration; however, it should want to renew with the supplier and put incentives and management structure in place that will encourage the supplier to renew, rather than going out to the market.

It really is not in the buyer’s best interest to sign contracts which are beyond the natural life of the technology or of the business. We at InfoServer recommend moving toward three- to five-year contracts and away from ten-year contracts. With a three-year contract, costs can usually be amortized, and there is enough time to peacefully enjoy the services.

There is a remarkable tendency for companies to start to chafe at their outsourcing relationships at about the second year; this is often when contract adjustments are needed. This “two-year itch” phenomenon is another reason why a three-year contract makes sense. An adjustment process can take three to six months and, if the supplier isn’t willing to work with the buyer, they’re not far from being able to go out to market. That implied threat of going out to the market puts the buyer in a strong position to make sure that there will be fair and equitable negotiations.

The best way that we’ve found to achieve flexibility is with a long-term master contract for a relationship that could last ten years (which is in the supplier’s interest), with adjustments to the shorter-term service agreements underneath it as necessary (which is in the buyer’s interest), and with added incentives along the line (in both parties’ interests).

Outsourcing is Built on a Paradox

Outsourcing, at its heart, exhibits a contradictory nature. One of its elements is the high cost of getting into or out of a relationship; this necessitates a long-term agreement in order to amortize the costs. A long-term deal is inherently inflexible because prices and metrics are projected into the future but decided at the outset; yet, because we cannot predict what the future holds, flexibility will be necessary to deal with changes. This paradox creates a tension — long-term relationship vs. flexibility.

Unraveling the Problem

In an outsourcing agreement, a company gives over the ownership and control of a business process to a supplier. Driving the deals to be long term is the high cost of the investment, and the switching costs if there is a change in suppliers. Outsourcing is basically a step change vehicle in which the supplier offers the buyer an opportunity to reduce costs and/or improve the services. The supplier then amortizes its investment to do that over a period of time; unfortunately, amortization of those up-front costs usually does not lend itself to changes and improvements.

Adding to the problem is the future. The parties must establish a base line for expectations, costs and services but, since we can’t predict the future, any base lines put together today — however well researched and thought out they may be — may not actually be the case in the future. They are based on where the buyer believes business conditions are taking it, what we believe technology will look like later, and what the current business objectives of the current management team are. In reality, the problem is that all those things are going to change over time and, the longer the relationship, the more they are going to change. Hence, the solution to the problem requires flexibility to deal with those changes.

Prescription to Restore Balance

A more flexible outsourcing arrangement can be designed by differentiating between the length of the relationship itself and the length of the contract. We believe the industry needs to continue moving toward long-term relationships but also to move toward shorter-term contracts.

Within most outsourcing deals that encompass several business processes, the different processes may change at different rates of speed. In IT outsourcing, for example, the underlying technology of desktop is changing at a much more rapid rate than mainframes. If you’re buying desktop services (and today no one knows what a desktop or PC will look like in five years’ time, let alone ten years), it is almost lunacy to buy it on a ten-year basis. Prices or metrics that are established at the outset are little more than a figment of one’s imagination. The buyer needs to be able to structure the contract without having to renegotiate the whole relationship.

The same principle applies in other areas. In outsourcing logistics, for example, the transportation piece is changing at a different rate than the warehousing piece. A different service agreement, customized to the warehousing component, with the transportation component separated out, would be a more flexible arrangement. Both parties must understand what is being bought. While it may well make sense to buy the components from the same supplier who can achieve synergies and economies of scale by combining them, technology and business changes will drive the components differently.

In structuring for flexibility, a master procurement vehicle, which would encapsulate most of the issues associated with how the companies will interact, should be established. It should then allow for a series of service agreements that can have different terms and vary by their core technology.

The other thing a buyer needs to do is to add incentives (or restructure the original ones) that will realign the supplier’s interest and motivation as the objectives change over time. A buyer does not want to get into a contract with an unnecessary long duration; however, it should want to renew with the supplier and put incentives and management structure in place that will encourage the supplier to renew, rather than going out to the market.

It really is not in the buyer’s best interest to sign contracts that are beyond the natural life of the technology or of the business. We at InfoServer recommend moving toward three- to five-year contracts and away from ten-year contracts. With a three-year contract, costs can usually be amortized, and there is enough time to peacefully enjoy the services.

There is a remarkable tendency for companies to start to chafe at their outsourcing relationships at about the second year; this is often when contract adjustments are needed. This “two-year itch” phenomenon is another reason why a three-year contract makes sense. An adjustment process can take three to six months and, if the supplier isn’t willing to work with the buyer, they’re not far from being able to go out to market. That implied threat of going out to the market puts the buyer in a strong position to make sure that there will be fair and equitable negotiations.

The best way that we’ve found to achieve flexibility is with a long-term master contract for a relationship that could last ten years (which is in the supplier’s interest), with adjustments to the shorter-term service agreements underneath it as necessary (which is in the buyer’s interest), and with added incentives along the line (in both parties’ interests).


Post a Comment

Your email address will not be published.

( required )

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>