Outsourcing: a service or business-based approach? (Part 2)
To read the first part of this article, click here.
The culture of control
One key aspect of the business outputs-based model for suppliers is that it relinquishes control of the methods of service delivery to the supplier: the supplier is measured and remunerated purely on the basis of the ultimate business benefit derived by the customer, and is free to deliver that benefit in the way it sees fit. Suppliers welcome this as it allows them to have greater freedom over the service inputs and design, enabling it to realise efficiency and cost savings without recourse to the customer. Provided the supplier delivers the ultimate business benefits required by the contract, the supplier has performed its side of the bargain. A service outputs-based model does not offer nearly as much of this flexibility to the supplier. The supplier is contractually mandated to perform the services in a specific way to meet a number of service delivery outcomes.
For customers, this is understandably a very big step to make. Whilst business benefits are important, the handover of control over service design for what can be a business-critical aspect of its company is not something to be done lightly, particularly if that service is heavily regulated or customer facing for example. For an FCA-regulated customer, it may not even be legally possible by operation of the Markets in Financial Instruments Directive. The handover of control is also predicated on the business outputs-based metrics being comprehensive and well thought out, and on the customer having significant confidence and faith in the supplier. Without these elements, the customer would be unwise to relinquish control in the service.
In practice, our experience is that customers tend to tread a middle ground here by only relinquishing control to the extent they are comfortable, but this tends to be a cautiously-taken line. For example, rather than simply contracting for the services to be “performed in a way to ensure that the customer complies with law” (with a related indemnity to cover any losses as a result of breach of this requirement), instead customers will mandate in detail how the services must be performed to ensure that the customer complies with law. This cautious approach can mitigate the customer’s concerns around relinquishing control, but it can also mitigate some of the other benefits brought by business outputs-based outsourcing – to an extent this approach mixes the downsides of a service output-based mechanism (i.e. increased cost as a result of retention of control by the customer) with the downsides of a business output-based approach (see “The measurement issue” below).
The measurement issue
One important aspect of a service outputs-based mechanism is that, in general, service outputs are relatively easy to measure on a regular basis, and further are intrinsically linked to the supplier’s performance of the outsourced services. This benefits both the customer and the supplier – the supplier has clear metrics by which to provide the services, and the customer has clear metrics which it can measure the supplier against and penalise them if they are not met. This is one of the key reasons why service output-based models are still one of the most popular ways of structuring outsourcings, and the key advantage that it has over a business output-based model.
The business output-based model on the other hand runs into significant challenges when you look at measurement of business benefits. Business benefit outputs by their nature tend to be more challenging to measure than service outputs. For example, customer satisfaction relies on the use of customer surveys (a measurement method which can be flawed), the realisation of cost savings relies on being able to determine what the cost would have been if the saving had not been realised (which relies on conjecture). Suppliers and customers should both shy away from business output-based metrics which cannot be readily and objectively measured, as these will simply lead to disputes in the future. Furthermore, in many cases it can be very difficult for fluctuations in business benefit metrics to be linked to the supplier’s performance of the outsourced services. For example with a consumer satisfaction metric, can it be proved that the supplier’s performance of the services was the only reason that a level of consumer satisfaction was or was not realised, or were there other factors in play such as the intrinsic value of the product/service being supplied? Again, suppliers and customers should avoid metrics which cannot be easily related to the supplier’s performance, as again these can lead to disputes.
Overall, the measurement issue presents a significant hurdle for business output-based mechanisms but this is not insurmountable. By using metrics which are capable of relatively objective measurement using methods which are agreed between the customer and the supplier up front, and metrics which are intrinsically linked to the supplier’s supply of the outsourced services, the parties can come to a position which will work operationally throughout the life of the arrangement.
A third way?
Given customers’ concerns around business output-based contracting, it is not surprising that hybrids of both this method and the service outputs-based method exist in the market. By having a set of tiered metrics, customers can link financial rewards and penalties to certain “tier 1” business output metrics, whilst having remediation remedies available for a set of “tier 2” service output metrics.
This hybrid method offers the partnership and risk-transfer benefits of the business outputs model, linked together with the comfort that a set of easily measured service output metrics brings. It is not, however, a silver bullet. In prescribing how the supplier is to perform, it reduces the possibility of cost savings and efficiency gains that a pure business outputs model can achieve, and it offers only remediation for failure to meet the service output metrics (rather than financial remedies) but it does offer significant comfort to a customer that wants to realise some of the benefits of the business output model whilst making a good attempt at avoiding the problems associated with the “measurement issue”. Suppliers may note that this model represents the customer receiving the “best of both worlds” though, and as a result may not be comfortable with it.
Where from here?
Ultimately, if handled properly, the move from service based to business based-outputs outsourcing is a positive one for suppliers and customers. It gives suppliers more flexibility and gives customers a significantly better chance of achieving the outcomes that motivated it to enter into the outsourcing in the first place.
However, the measurement issue makes business output-based outsourcings more complex and, without a sophisticated set of metrics, can pose a risk to customers and their suppliers. Accordingly, when considering whether the business outputs-based approach is the right one to take, significant resource should be put into assessing if a reasonable set of metrics can be devised which are capable of objective measurement, which adequately capture the ultimate business outcomes that the customer wants to achieve through the outsourcing, and which can be linked to the supplier’s performance. This may not be possible for all outsourcings but ultimately if this can be achieved, the partnership created between customer and supplier will be stronger and the benefits to the customer can be significant.
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.