Problematic Areas of Cost | Article

pensive outsourcing man on coinsWhen asked how the cost of outsourcing transactions can be reduced, Dennis McGuire, president of Technology Partners International, says that the most problematic area occurs before the contract is signed. The largest source of costs, he explains, lies within the process of negotiating the contract.

The Negotiation Process

The first of five pieces to the contract phase of an outsourcing deal, says McGuire, is the assessment process, where the request for proposal (RFP) is developed. This is a relatively inexpensive process. The second phase is to send the RFP to potential suppliers and evaluate their responses.

Phase three–down selecting three potential suppliers to two?is expensive, according to McGuire. Both parties then perform due diligence, and negotiation takes place. This phase takes the longest amount of time, he explains, especially if it is an international deal where there is a lot of travel. “It is during phase three–where each side makes sure of what it is getting–that you can spend millions of dollars in due diligence,” says McGuire.

Two other activities happen in this phase. “The supplier has to give the buyer a solution in terms of how the supplier is going to do a process better,” he says. “This is a significant point because it will take the supplier a little while to figure out how to do it better.” The next part of phase three is the transition plan–getting from where the buyer is today to the new solution of the supplier.

Phase four is where the multi-year pricing is determined. The fifth phase is governance–how the company is going to manage the deal after it is signed.

Problem Spot

What sometimes happens, McGuire points out, is that executives decide to sign the contract before they have figured out the solution, the transition plan, the multi-year pricing and the governance. “Unfortunately, it takes them twice as long to do those things after they sign the contract as it does to do them before,” he comments. And the costs add up.

Switching Costs

The buyer’s high switching costs–or early termination fees–are an area where costs can be reduced. McGuire explains two options for a better way to handle the fees. A reasonable termination for convenience fee, he says, should be the value of the unamortized one-time cost of implementing the deal and a pro rata portion of profits. The supplier is paid for its time and is reimbursed for costs that it incurred but was not able to charge the buyer for.

As an example, a buyer may have signed a five-year contract, and it will cost the supplier $10 million to implement the contract. The supplier will amortize costs over five years and look to recover $2 million each year. The supplier also needs a pro rata portion of profit. Suppliers often make no profit the first year, so the contract allows termination for convenience after year two. To terminate early, the buyer will need to pay the supplier’s unamortized one-time costs of $6 million (at the end of two years, there would be $6 million left) and also pay a pro rata portion of profit for the first two years.

A second option provides for the new supplier to pay the termination charges to the former supplier, instead of footing the usual transition charges. As an example, the buyer in year three of the deal decides it wants to switch to another supplier. “The beauty of this is that the new supplier does not have to deal with the people issues or buy assets,” McGuire points out. “So the cost the new supplier would normally incur is less. Most importantly, in many cases it’s not too much different from the termination for convenience charge that the current supplier will charge.

“Where the parties have signed a really fast deal,” warns McGuire, “I can assure you that the buyer is not going to have a very fair termination charge because it lost its negotiating leverage. You’ll find that the supplier has all the profits for the whole contract, not just a pro rata profit. It all depends on whether you knew what you were doing when you negotiated your contract.”

Dangerous Area

McGuire says many companies attempt to save money in the areas of mainframe and mid-range processing. The area where it is most difficult to obtain savings is desktop services. “Most companies already aren’t spending enough on desktop, yet they want it cheaper. What happens is they get something cheap and customers that work with it every day don’t like it and get hostile. It puts a negative pale on the whole deal,” he says, “and that makes it dangerous to try to save money on desktop services.”

One area where customers can save money is in communications. McGuire says it is now fairly easy to save money in this area because prices continue going down so fast.

Offshore Strategy

Often, suppliers with locations in India or other international locations can offer services better, cheaper, and faster. It would seem, therefore, to be a wise move on the part of buyers to select a supplier with offshore facilities and resources.

McGuire points out, though, that buyers need to give consideration to where the offshore locations are. It is difficult to have real-time dealings with someone in Asia-Pacific or Europe, where there is a window of only a couple of hours to speak together.

“For buyers whose companies are located in the United States, I really like offshore in Canada and Mexico more than India,” he says. “You are in the same time zone and are closer. There are some pretty dramatic differences in costs between the US and Canada or between Mexico and the US. Yes, you can definitely save money in offshore,” but I would first try to save money on our continent.”

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