Outsourcing Nightmares: outsourcing no-nos – and how to avoid them
The vast majority of mistakes made when outsourcing can easily be avoided if a company prepares properly at the outset, has realistic expectations of what sourcing can achieve and engages with potential service providers in an organised and methodical way – which should enable it to secure the best deal. Of course, each sourcing transaction will have its own unique features. However, detailed below are some of the common areas where mistakes arise, with some suggestions as to they can be avoided:
1. Unfulfilled expectations
Many companies (especially those embarking on first-generation sourcing transactions) believe that outsourcing a “troubled” environment to a service provider will enable those issues to be resolved overnight. This is unlikely to be the case. Therefore, companies must be realistic: it will take time for the service provider to implement their more structured ways of working, to potentially upgrade the skills of the transferred work-force and, where relevant, to effect technology upgrades and thereby transform the environment.
2. Failure to achieve the best deal
A substantial number of companies will engage with prospective service providers without having real clarity as to the scope of activities which it proposes to outsource. To achieve the best deal, a company must prepare well, by developing and documenting a clear scope of work – by identifying precisely what activities are in scope, measuring and recording the actual service levels which the business is currently receiving and assessing whether securing enhanced service levels (which could increase costs) would benefit the business. It should then create genuine competitive pressure, by inviting a number of prospective service providers to bid against that scope. This will enable the company to compare each service provider’s proposal and make a “like-for-like” assessment. In addition, without this clearly defined scope, it will be impossible to accurately assess whether all the activities which the company assumes are included within a service provider’s proposal are in fact included – or could give rise to additional charges.
3. Lack of understanding as to existing costs
It is essential for a company to understand its own costs of operating the environment which it is proposing to outsource. These should include not only the direct costs (e.g. the effected employees and software licences), but also real property costs, financial, administration and human resources costs and any other overhead allocations). Without this information, it is impossible to accurately assess the competitiveness of any financial proposal which a service provider puts forward – and what (if any) financial benefits can be achieved. Having created a financial model reflecting the “as is” position, that model should then be used to assess each of the service provider’s financial proposals.
4. Don’t down-select too early
Having created a genuinely competitive environment, many companies are too easily persuaded by one proposed service provider to engage with them on a sole-source basis – by assurances from the service provider that it will enable the deal timetable to be accelerated and the service provider will be able to offer a better deal. These assurances rarely come to fruition. Ideally, down-select should not occur until all material terms have been agreed with the preferred service provider, and a record of such agreement prepared (e.g. in the form of a term sheet). Even after down-select, a company should look to keep one of the other service providers “warm”, so that in extremis they can be brought back into the process.
5. Nothing is certain
A company must recognise that their requirements will inevitably change during the term. A contract which is “cast in stone” will not be fit for purpose, will be difficult to operate and inevitably expensive to run. Instead, a contract should allow for flexibility (in terms of volumes, service levels and potentially scope) – ideally without requiring the express agreement of the service provider. For example, if a company anticipates merger and acquisition activities during the term of the engagement, the contract should provide that the company can, as of right, bring any acquired entities into the scope of the arrangements on a pre-determined basis. “Change” can be expensive, as the change control process can potentially be manipulated to create an additional income stream for the service provider. Ensure there is predictability of change by having an agreed costs standard.
6. Pricing and value for money
There are a multitude of different pricing structures which can be applied (including fixed price, capped price, target charge, open-book etc.). A company should consider carefully what its objectives are and which structure will work best. If the volume of consumption will be highly variable, then consumption-based pricing may be most appropriate. By contrast, a constant and predictable level of consumption may make a fixed price structure (with the attendant certainty of costs) most appropriate.
7. Best to avoid
As a general rule, a company should avoid giving exclusivity, making minimum revenue commitments or using a sourcing contract as a vehicle through which to carry out “financial engineering”. There may be very specific reasons why they may be appropriate, but a company should only accept such provisions if it has fully assessed and is willing to accept the consequences which will inevitably arise.
To read more of our lead feature on ‘Outsourcing Nightmares’ from the Autumn 2014 issue of Outsource, see the article index here.
About the Author
Peter Dickinson is Partner and London Head of Corporate for law firm Mayer Brown.