Why We Need to Talk About Risk | Article
Outsourcing has its own four-letter word: risk. Risk is the elephant in the outsourcing kitchen; it’s the problem everyone knows they have to handle but no one wants to talk about.
However, one of the ways to ensure a buyer and supplier craft a successful outsourcing transaction is to deal with risk at the outset in a straightforward way. I believe outsourcing relationships would become more effective if all the players stopped tiptoeing around this topic.
During the negotiation phase, both parties try to determine the risks involved in doing business with each other. Using various tools, they attempt to quantify those risks. Then, the big game is to shift all the risk to the other party.
I’d like to amend that process. I propose that both parties define the risks together. Then they jointly should determine if there is a way to mitigate any of the risks. Finally, they can decide who is going to bear each of the risks that remain. Once they have divvied up the risk, they can price the deal fairly. Knowing who is going to bear what risks also helps them put together a powerful and workable governance structure.
How Do You Determine Risk?
Everest has developed many ways to address risk. One popular method is to quantify the risk.
Buyers believe they face five types of risk when they outsource:
- Financial. A risk that could change the expected financial outcome of the solution.
- Operational. A risk that the solution would prevent the business from meeting current or evolving requirements.
- Organizational. A risk that hinders the organization’s ability to enable the desired outcomes.
- Legal. A risk that creates legal penalties.
- Strategic. A risk that the solution would not support the strategy of the organization.
The Everest process examines each of these five areas and assigns a risk score for each category. The higher the risk, the higher the score; one is the safest option; five is the riskiest.
First, we chart two risk profiles: the buyer’s current risk profile as well as one based on the business results the buyer hopes to achieve. Then, we plot the profiles of each solution option so the buyer can compare the current risk profile against the various solutions. This process enables the buyer to compare risk profiles of different solutions, which is instrumental in selecting the optimal solution.
Spider Charts Help Buyers Visualize Risk
We use a “spider” chart to show this graphically. The chart enables the buyer to “see” the risks involved, compare the risk profile of each option, and determine the one most appropriate for its needs.
For example, say the buyer’s primary business driver was to significantly reduce costs. If the risk profile indicated that going offshore (Option C) would present higher operational and organizational risks, it would receive a higher score. In this example, the buyer assigned values of 3.5 for operational and organizational risk and 4.5 for financial risk. Another solution, outsourcing to a domestic supplier (Option B), provided less financial and strategic risk. Other elements of Option B’s risk profile were either equal or slightly higher than Option A, which kept the process in house.
In this example, the risks associated with going offshore are probably unacceptable. That decision made, the company can then focus its efforts on working with the domestic supplier to optimize the supplier’s solution. Finally, the buyer will have to compare the supplier’s offering to an internal option.
The next steps in the risk analysis answer these questions:
- What is acceptable risk?
- What risk mitigation plans are needed?
- How does mitigation impact the solution’s risk profile?
Essentially, this process helps the buyer gain deeper insight into the elements of risk for each solution option. It also enables executives to evaluate changes to the risk profile of any given solution by changing its design. Modeling risk is an iterative process; this approach allows the buyer to track the changes in the risk profile of any solution.
Quantifying and assigning risk is a crucial factor in outsourcing success. It’s time to get the elephant out of the kitchen.
Lessons from the Outsourcing Journal:
- Both parties need to discuss and understand risk during the solution development phase so that the solution design will mitigate service delivery (and pricing) risk. Allocation of risk will ultimately be “cast in concrete” as the contract is negotiated.
- Risk premiums are a significant factor in supplier cost models. Price will follow assumption of risk. If both sides can’t mitigate the risks, buyers and suppliers should assign risk fairly. Fair pricing and good governance will result.
- Risk analysis allows buyers to evaluate supplier options according to five types of risks — financial, operational, organizational, legal, and strategic — so they can decide the best course of action.
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