Cost and price. It’s crucial that buyers understand both when it comes to outsourcing. What is the cost of providing business services internally? What elements comprise that cost? What is the price for comparable services from an outsourcing service provider? What cost elements affect the provider’s price? For the service levels it commits to perform, is the provider’s price comparable to its competitors?
Undertaking a benchmarking study is the way to determine if outsourcing can deliver the same services at a lower price or better services at the same or lower price as the buyer’s internal cost. If the buyer then decides to outsource, it has benchmark data, rather than just assumptions, for a baseline on which to structure the provider’s services and points to use in measuring the outsourcing solution.
Over the years of the contract term, a buyer can also use periodic benchmarking studies to assess whether or not the provider’s prices are fair and competitive as the market changes or the buyer’s situation changes over time and when it’s time to consider renewing a contract.
Including a contractual clause on benchmarking
Most outsourcing contracts today include a benchmarking clause, allowing the buyer to periodically benchmark the provider’s services and price in comparison to other outsourcers. The contractual clause might also specify which benchmarking organization the buyer may use, or it might specify that the parties need to agree on the firm at the time of undertaking the benchmarking study.
The contractual clause may also specify the process that they will use in conducting the benchmarking study as well as the type of results to obtain. For example, should the benchmark data focus on best price, average price, or a certain percentile such as the top 10 percent of prices?
Despite the fact that a buyer may conduct benchmarking initiatives every one or two years, it is important to realize that there is a time-lag factor that affects the validity of the data. Completing a benchmarking study takes time. In addition, depending on the source of the market data, the data might be six months or even a year old.
Examples of when and why to benchmark
Buyers use benchmark data to initially determine the financial benefits of outsourcing; they also use benchmarking to validate pricing and service levels over the length of a contract. The benchmarking examples that follow are of relationships that Outsourcing Center studied in 2004 – 2009 in its annual Outsourcing Excellence Awards program.
Using benchmarking to determine the financial benefits of outsourcing
Case example #1. Cost reduction was the buyer’s objective, but its CEO mandated that no cost-cutting strategy could result in sacrificing the level of production of quality of the work. The company recognized that it would achieve the greatest cost reduction through labor arbitrage in an offshore outsourcing solution. It then conducted a benchmarking study of onshore and offshore outsourcing providers’ solutions to determine their quality and performance benchmarks against their prices.
Case example #2. A European company with a shared-services unit for its HR and finance and accounting services conducted a benchmarking study to determine if its support functions were better or worse than average compared to its competitors. The benchmark data revealed that some services were at competitive levels, but some were worse than average in its market. The buyer decided to close its shared-services unit and outsource those processes to ensure a high level of service in all functions.
Case example #3. A buyer in the utilities sector decided to outsource to reduce its costs. However, its competitors had not outsourced the scope of work this buyer wanted to outsource, so there were no relevant benchmarks to support the business case. The buyer undertook a benchmarking study of similar scope in several other industries in order to obtain the data that demonstrated to the company’s executives and board that outsourcing was “the right strategy to take.”
Case example #4. A benchmarking study of a company’s internal service levels and costs revealed that its costs were comparable to its direct competitors. However, its cost base was higher than “world-class” in the area of return on IT spend, so the company decided to outsource in order to obtain world-class services at a lower price.
Case example #5. When the buyer in this case experienced more than average customer churn, it recognized that it needed to ratchet up the quality of its service. It conducted a benchmarking study to compare its services and prices with the market. The study’s data helped the company’s executives realize that getting to the level of the external benchmarks would take too long for the company to accomplish with its current level of resources. The benchmarks thus validated the value of the increased price to outsource the work and quickly achieve the desired level of service.
Case example #6. Competition is always an effective mechanism for lowering prices; this is the reason many buyers negotiate with two service providers as they work toward a final solution and the selected provider’s price. However, the buyer in this case preferred a sole-source approach since it had an existing relationship with the chosen service provider in another region but for a different scope of services. In this case, the buyer conducted a benchmarking study to compare other outsourcing providers’ service levels and prices so that the sole-source approach would still have a “competitive” approach in determining the price of services.
Benchmarking tip. It’s important that the benchmark study buyers use to compare their internal cost of delivering services comes from benchmarking right before they turn to outsourcing, rather than from a point in time further back. This data will form the baseline to use in comparing to the provider’s service level.
Using benchmarking to validate the outsourcer’s pricing on an ongoing basis.
The initial baseline in an outsourcing deal will inevitably become problematic. Market conditions, new technology, and new objectives in the buyer’s business will affect the validity of that baseline over time.
Case example #7. After three years of significant changes in outsourcing solutions for the healthcare industry, the buyer in this case suspected it was paying too much for its provider’s services. It conducted a benchmark study to “gain a sanity check” in terms of the types and levels of services it could expect to get elsewhere for the same price and then used the benchmark data to renegotiate the contract to include new services that were not available at the time they signed their original contract.
Case example #8. In this case, the buyer felt that the parties had negotiated into the contract a certain level of “flexibility” regarding ramping up resources, but the provider disagreed with the buyer’s assumption. They undertook a benchmarking study to have factual data instead of “feelings” as they worked through the process of determining the fair price.
Case example #9. In this relationship, where the multinational buyer outsourced global services, the parties took a phased approach to bringing each geographic region into the scope of the provider’s responsibility. They use their benchmark data to compare each region against the others to make sure each region receives the same level and quality of services. Where there are gaps, they then change the service levels to include a penalty or reward to incentivize the provider to quickly close a gap.
Case example #10. Continuous improvement and yearly cost reduction are contractual mandates in this relationship. The buyer annually obtains market benchmark data to ensure the evolving services and associated costs are comparable or above the market average.
Case example #11. When a new CEO took the helm in this buyer’s business, he mandated that all business units periodically validate how their performance aligns with the company’s business objectives and budget. Validation in some BUs was a challenge. However, those that had outsourced were able to adequately benchmark service level performance and validate every cost aspect of the provider’s cost structure.
Case example #12. This buyer believed its service provider was padding its profit margin by employing too many people on the account. After obtaining benchmark data, the provider agreed to reduce headcount. In addition, the provider discussed with the buyer how they could jointly improve the process to maintain the service level with fewer people.
Benchmarking tip. Benchmarking is a tool that can help buyers maintain flexibility for change during a long-term outsourcing relationship and take advantage of evolving technology and services. However, when it comes to discussions with the provider about changing a pricing model or renegotiating the contract, the discussion can become adversarial. After all, the buyer wants to minimize its costs and the provider wants to avoid price reduction so it can maintain a profit.
Both parties need to remember that outsourcing is a relationship-centric and long-term business model. It works best when the parties address all new issues and opportunities (including issues around benchmark data) from a win-win, partnering approach.
Lessons from the Outsourcing Journal:
- Buyers use benchmark data to initially determine the financial benefits of outsourcing or to validate pricing over the length of a contract.
- Buyers are wise to include in their outsourcing contracts a benchmarking clause, allowing the buyer to periodically benchmark the provider’s services and price in comparison to other outsourcers.
- A contractual clause about benchmarking might specify which benchmarking organization the buyer may use, or it might specify that the parties need to agree on the firm at the time of undertaking the benchmarking study.
- The buyer needs to decide what type of benchmark results it wants to obtain. Results could, for instance, focus on best price, average price, or a certain percentile such as the top 10 percent of prices.
- Outsourcing is a relationship-centric and long-term business model. It works best when the parties address all issues surrounding benchmark data from a win-win, partnering approach.