Typically in an outsourcing deal, the parties develop a baseline of where they believe the business will go, and they structure the transaction on that basis. The problem is that the baseline inevitably will be wrong at some point in a long-term relationship. The baseline assumptions are early assumptions, and it is impossible to know how technology, market conditions or business objectives will affect and change those assumptions over a period of years. Because of high costs involved in getting into and out of relationships (for both buyers and suppliers), outsourcing deals usually are structured for a period of five to ten years. With changes almost guaranteed during that length of time, an outsourced process becomes a moving target, so to speak.
The key to dealing with this issue is, obviously, building flexibility into the relationship. Excellent suggestions, such as using sliding price scales and services on an as-needed basis, and using shorter-term service agreements were presented in the March issue of OutsourcingJournal; and we encourage readers to review that information. But, once they find themselves in the middle of changing technology and objectives, how can outsourcing participants make their relationship work in a meaningful way? What can they do to preserve the integrity-the original intent-of their transaction and the spirit of their alliance?
The Illness: All or Nothing
A comedian named Joseph Levitch started on the vaudeville stage at age 12 with his parents; by age 18, he had put together a nightclub act where he pantomimed popular songs. Often, he was on the same bill with a crooner, Dino Paul Crocetti. No one took much notice of either of them, until they began stepping into each other’s acts. The results were hilarious, and overnight they became stars.
The two officially teamed up in 1948. Dean Martin and Jerry Lewis became a comedic duo that is unequalled in popularity to this day. The Martin & Lewis Show television variety series began in 1949; after that, they starred together in 17 enormously popular movies in a period of seven years. They made each other’s careers; they made each other successful. Their intent was to achieve comic brilliance.
But the original intent of their alliance changed. About the same time that Jerry began driving the team to grow, Dean’s desire to do comedy cooled down. Martin wanted to spend some time pursuing a singing career and just keep the comedy act as a part-time venture. Their objectives changed. Lewis was inflexible and refused to let Martin pursue his singing career; he wanted all or nothing from Martin. Their breakup in 1956 devastated both of their careers. Both continued to pursue acting roles in comedy movies. Although their single achievements after the break-up are significant, neither achieved the success or brilliance they had mastered while working as a team.
This same paradigm often occurs in outsourcing. As technology and market conditions change, the parties’ differing objectives will drive them to a split unless they find a way to recapture the original spirit of their alliance.
The Diagnosis: Realignment
In outsourcing, both parties begin the relationship with the intent of achieving a common goal — the creation of value. For the buyer, value is created in reduced operating costs, access to the supplier’s world-class expertise and resources and availability of the supplier’s capital funds, among other things. For the supplier, value comes in the revenue realized from running the process the buyer has outsourced. The spirit of their alliance is a motivation to work together to achieve successful results in the outsourced process so they will both realize value. Still, their perspectives diverge from the outset. The supplier wants to maximize its upfront investments as long as possible; the buyer wants lower costs and/or better products and services.
As long as they continue along their baseline assumptions, all is well. But when the buyer’s organization wants to realign itself with changing technology or business conditions, its objectives change. The buyer’s motivation changes at this point, but the supplier’s motivation is still monetary. In a situation where the supplier is no longer aligned with the buyer’s new objectives, there will be nothing but frustration and dissatisfaction on both sides. Even successful teams break up when their interests–or rewards–are no longer aligned. The supplier’s interests must be realigned with the buyer’s if they are to continue their relationship.
The Antidote: Incentives and an MPV
In this issue of OutsourcingJournal, Doug Elix, of IBM Global Services; Richard Lefevbre, of Simpson Industries; and analyst Dennis McGuire, of Technology Partners International, share suggestions on how to preserve the integrity of outsourcing relationships.
We at Everest have seen that, historically, the best way to recapture the original intent and integrity of the relationship is through incentives. The buyer will receive only what was originally contracted for unless the supplier is financially motivated to provide market-driven improvements. If you look at where the buyer’s business is headed, there is opportunity for a win-win situation if the supplier’s resources can be tapped to get there. If you build incentives around getting there, the supplier’s interests will be realigned with the buyer’s.
One of the best, yet seldom used, incentives is contingency-based pricing. This is risk sharing, based on results; and a premium is paid to the supplier only if the desired result occurs. One example of the use of contingency pricing was seen in the petrochemical industry. The industry established early development and target costs for deep-sea oil drilling equipment as an objective. The suppliers’ incentive to bring the projects in for less than the targeted cost and earlier than the targeted dates was a pro-rata split of the savings. If this approach interests you, you may wish to obtain further information from a research project on the subject of contingency-based pricing (Risk Reward Pricing), which is available from Outsourcing Center.
Another effective and flexible means of preserving the original integrity is through use of a master procurement vehicle (MPV). An entire contract should not be put at risk because of minor changes. The parties need the ability to change the gain-sharing mechanism of the relationship in order to realign the compensation with the new objectives.
With a standard contract, the total compensation and reward tend to be spread out over the length of the contract, making it difficult to be flexible as needed. The supplier is put in a position where its back is against the wall and it faces losing business if the buyer wants to initiate new business objectives.
An MPV separates the business issues and processes from the legal and contractual issues. The MPV is made up of separate service agreements and metrics, with separate term lengths appropriate to each, which are attached to the contract. The best practice is to make the length of the term fit the rate of technological change. For example, since there is no way to predict the technological and business changes that will affect desktop services in a five-year period, the service agreement for desktop services should be for a term of two to three years. Using an MPV permits better understanding of what the buyer is buying, how to measure the results, and how to determine fair pricing. More importantly, it allows a way to introduce shorter-term business initiatives with their separate compensation and incentive rewards. With an MPV, new services can be added at any time without destroying the overall relationship contract.
Each approach is good–whether it is an MPV, incentive-based pricing, or other ideas presented in this issue. What is incumbent for the good of the industry is that we find ways to make flexibility meaningful so that we can maintain the original spirit and intent of outsourcing alliances in the midst of changing objectives.