Outsourcing: a service or business-based approach? (Part 1)
The challenge of effective procurement and measurement of an outsourced service arrangement is one which has never quite been solved throughout the 25-year history of the outsourcing industry. Even today, in putting together deals, suppliers and customers still struggle to find a solution which works to meet both parties’ respective goals and concerns. The reason for this is due to the myriad of methods in which the effectiveness of an outsourcing can be measured and the linkage of remuneration to those measurements of effectiveness. All of these methods have significant advantages and disadvantages, both due to their inherent nature but also due to the culture of the suppliers and customers that seek to implement them. This article explores these different methods, and looks at the current shift to a new business outputs-based measurement and remuneration mechanism, from the more traditional service outputs-based mechanism.
Defining service outputs-based and business outputs-based mechanisms
At their very basic level, both of these types of mechanisms are simply measurements of certain aspects of the outsourced arrangement with certain targets attached to them, which are in some way linked to the remuneration of the supplier. The contractual mechanisms by which these measurements are linked to the remuneration of the supplier are not covered in detail within the scope of this article; however the nature of the measurements themselves (i.e. what aspect of the outsourced arrangement is being measured and how this affects service delivery and the overall relationship between supplier and customer) is the key aspect of whether the outsourcing is service outputs or business outputs-based.
As its name suggests, a service outputs-based measurement regime measures those things that the supplier directly outputs from the services. These of course completely depend on the nature of the service itself – for a contact centre outsourcing, service outputs measured might be percentage of calls answered or average call handling time, whereas for a logistics outsourcing the service outputs measured might be deliveries on time, pick times or stock call-up times – however ultimately the nature of these measurements are the same in broad terms, they measure the supplier against component elements of the overall service delivery. They turn the spotlight onto certain micro parts of the whole machine. These traditional service measurement types of mechanisms are often combined with a traditional remuneration regime based on, for example, a fixed price per FTE, or price per “productive hour”.
The business outputs-based approach is a relatively recent development in the outsourcing industry. Instead of measuring the supplier’s direct service output, the parties instead measure the supplier’s delivery of business benefits to the customer. These benefits may be somewhat more removed from the supplier but overall have more direct relevance to the success of the customer’s business. For example, for a contact centre outsourcing, measurements might include consumer satisfaction or number of consumers retained, and for a finance and accounting outsourcing, cost savings made or increased efficiency realised. However, once again the fundamental nature of these types of measurements is the same: a measurement of the supplier’s contribution to some aspect of the customer’s business.
Given the nature of these arrangements (i.e. more directly measuring the supplier’s impact on the customer’s business), the remuneration structure will often also reflect whether the supplier delivers a business benefit, with the remuneration increasing or falling accordingly.
Why move from a service to a business outputs-based mechanism?
Both mechanisms have significant benefits, but there are a few key considerations to take into account when deciding which approach to adopt.
A partnership approach
The most successful outsourcings for all parties involved generally are those where the customer’s desired outcomes and the supplier’s incentives are closely aligned. Business output-based contracts achieve this closer alignment better than service output-based models, by aligning the achievement of the customer’s ultimate business goals with performance measurements and incentivisation as well as the supplier’s remuneration. This leads to business outcome-based contracts often being approached on a more partnership-based level, both parties having a common goal to work towards.
However, the downside of a partnership-type approach for the customer is that, if approached in true partnership style by both parties, there must be a sharing of risk and reward by the customer to reflect that the business benefits sought are a combined goal. If the supplier is to be penalised (by way of reduced remuneration) for a failure in delivering a business benefit to the customer, it is not unreasonable that the supplier would demand a right to a cut of any over-delivery against those same business benefits. Without this, the supplier shares the risk of underperformance with the customer, but gets no share in the potential upside as a result of overperformance and there is a lack of real alignment between the parties’ objectives and incentives. A further downside to the partnership-type approach is that the mechanisms are difficult to construct, and take significant negotiation to get right, whereas a more traditional approach might be an easier process to get right.
Accordingly, if a customer wants to reap the upsides that a partnership-style outsourcing can bring, it must be prepared to accept that this is unlikely to be a one-way sharing of business benefit.
Binding the supplier to its promises and transferring risk of performance
Many outsourcing customers in the past will have witnessed significant business benefits being sold by outsourcing suppliers during the RFP phase of a transaction, only for those business benefits to fail to materialise once the deal is done. The primary reason for this occurring is because, in a traditional service output-based model, the risk of whether those business benefits will be achieved remains with the customer at all times – it is the customer’s responsibility to evaluate whether or not the service outputs provided by the supplier will translate into business benefits. Once the service output-based contract is signed, the supplier need no longer worry about the potential business upsides, it need only perform against its service delivery metrics – accordingly the business benefits sold at RFP stage may not be as truly achievable in the real world as the customer might hope.
The business outputs-based model shifts this risk from the customer onto the supplier. By adopting a model where the supplier’s performance is measured by reference to business outcomes, the supplier must perform against its claims made during the RFP phase. This leads to a number of upsides for the customer, notably it receives realistic bids during the RFP phase which enable it to properly evaluate whether the outsourcing will achieve the customer’s ultimate goals, and which supplier is providing the best proposition on a “real world” basis.
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About the Authors
Alexander Brown is a partner in the Information, Communications & Technology Group at Simmons & Simmons, advising on outsourcing and commercial ICT contracts for users and suppliers of ICT products and services. He also has a particular specialism in data protection and privacy. His experience includes handling large-scale, complex outsourcings (both IT and business process), software development, licensing and maintenance, telecoms supply and procurement contracts, major commercial contracts for the supply of goods and services and assisting clients in a variety of industries on all aspects of privacy compliance.
George Morris is is a supervising associate in the Information, Communications and Technology (ICT) group at Simmons & Simmons in London. He specialises in all types of general commercial contracts, with a particular focus on outsourcing, IT, infrastructure sharing and telecommunications.