December 12th, 2007
Choosing a service provider is kind of like choosing your significant other. The variables are complex and the consequences expensive, so you’d be wise to do your homework before getting involved.
What’s the candidate’s track record? Does it have a fear of commitment? Would it be a good personality fit? Do you get the feeling it’s hiding something? All are important questions when you’re shopping for a relationship, and that includes outsourcing. So you check out the provider’s history, assess its long-term potential, seek out any hidden information, and otherwise obtain the data you need to decide on a partner.
That applies not only to provider capability, but also to financial factors, which are a key means of differentiating one service provider from the next. Following is a cursory view of the top 10 financial differentiators to look for when you’re comparing service providers for business process outsourcing (BPO).
1. Transition costs. Beware the provider that proposes an upfront payment or a schedule of payments that isn’t tied to the transition progress. Instead, look for one that agrees to milestone payments that are aligned with key transition goals, such as the implementation of hardware and software or the relocation of your servers to the provider’s data center. In the case of one global food and beverage company that structured its payments based on milestones, the BPO transition fell behind by about three months — and, therefore, so did the payments, which saved the company cash out of pocket. Milestone payments can help keep the transition on track and, in the event of a delay, ensure that you’re not paying for underperformance.
Also consider a provider’s methodology for elements like knowledge transfer, risk analysis, systems transition, project management, hiring and training. Such established methodologies usually will bring lower costs both for the transition and later operations. Another key driver is duration: The longer the transition period, the longer the delay in your operational savings — and the higher your overall transition cost.
2. Transformation costs. As one railroad company prepared for outsourcing, the projected transformation costs continued to increase as the provider tacked on charge after charge for the implementation and customization of software. In the end, the buyer wisely chose a different partner, one willing to lock in on transformation costs and commit to promised results.
The key is to find a provider that will assume some risk during the transformation process. If a server consolidation isn’t completed on time or doesn’t generate the expected savings, for example, then that loss should be borne by the service provider, not the buyer. The opposite approach in more risk-averse providers is to charge for time and materials — which potentially gives them an open checkbook.
3. Inflation and currency. It ultimately doesn’t matter where you start in your IT or BPO negotiations; it’s what’s in the contract that you have to live with, so pay close attention to key business terms like inflation and currency. One multinational food company negotiated an annual inflation cap of 5% for service centers in India, and this agreement insulated it from inflation rates that are now in the double digits. A large U.S. pharmaceutical company, as another example, was outsourcing part of its back office and planned to expand to global locations down the road. So, with an eye toward the future, the company built provisions into the original agreement that mitigated the risk of inflation and currency fluctuation — and those terms are now serving the company well as it enters new countries.
Some service providers manage their inflation risk by building projected price increases, tied to a specific index, into the contract. Others establish thresholds of fluctuation, beyond which the price may go up. Still others try to avoid currency risk altogether by structuring agreements at the local or regional level, as such handling all billing in the currency of each location. Ask service providers how much inflation and currency risk, if any, is built into their rates, and then negotiate from there.
4. Labor arbitrage. Sourcing the right work to the right location can usually deliver high quality at a substantially lower cost, which makes a provider’s geographic footprint an important differentiator. For transactional processes, seek a service provider with the ability and facilities to move your work into global, wage-favorable locations. For higher-priced, less-transactional processes, look for a provider that can leverage offshore or near-shore locations to access specific skills while maintaining language and cultural continuity.
5. Provider productivity. The expectation in an outsourcing deal is that savings will be generated over time through ongoing improvements in productivity and efficiency, but that requires service providers to make a financial commitment without knowing exactly what those improvements will be. Look for a provider that demonstrates knowledge of its price drivers and business model by locking in a price and showing a continuous decrease over the contract term. For instance, Dell Inc. is among the many service providers that are committing to a price reduction of 2% to 3% annually in Years 3 to 5.
This kind of practice guarantees that for the scope of the deal, the productivity is built in.
6. Projects. A related differentiator is a provider’s approach to projects: What kind of work — and how much of it — is allowed as part of a deal before the provider charges an additional rate? A disagreement over the handling of projects, incidentally, is said to be one of the reasons that Sprint Nextel Corp. sued IBM last year, claiming the provider didn’t meet productivity expectations.
If ongoing productivity improvements and other steady-state projects are not called out in the “statement of work” (and they usually aren’t), then we encourage clients to capture this work in the baseline service levels. In one BPO agreement, a pharmaceutical company knew that ongoing enhancements to the ERP might involve 40-hour workweeks for some 25 annual projects. So the company made sure these projects were included in the base fee, lest it get billed extra for projects that should be an inherent part of its outsourcing.
7. Price visibility. Providers like to bundle several services for a packaged price, but it’s better for buyers to see itemized prices for specific services. This way, you know clearly what you’re paying for, and you can compare prices against other service providers. Moreover, the providers that will decompose their pricing are usually easier to work with in the long run.
When comparing prices, evaluate the implied unit rate for each service component. In addition to the direct cost of operations, for example, a provider’s unit rates may include all or a portion of transition costs, risk contingency and project management costs. Asking providers for this level of visibility will help determine whether they have a firm grasp of their cost structures.
8. Service-level credits. Service levels are vital measurements of provider performance, so it’s standard practice for providers to be penalized — in the form of service-level credits — if they miss the target. In evaluating these credit systems, which can range from 8% to 15% of the monthly contract, seek providers that will accept a high penalty, which demonstrates confidence in their work. For example, one global IT and BPO provider was so sure of its capabilities that it didn’t argue the penalty at all, instead saying, “If we can’t deliver on our service commitments, we should be held financially accountable.”
9. Termination. In multiyear outsourcing deals, early termination is always a possibility, and it always has a price tag. Just recently, for example, Sears, Roebuck and Co. and Computer Sciences Corp. finally ended a termination dispute from 2005, when Sears decided it wanted out of its 10-year contract for IT infrastructure — just a year after signing it. The dispute focused on whether Sears was escaping for convenience or cause, a determination worth tens of millions of dollars.
When it comes to termination for convenience, the fees are typically in three categories: â€œcapped wind-down assistance,â€ â€œunamortized assetsâ€ and the â€œbreakage fee.â€ If you agree to â€œunwindâ€ the provider’s support operations and compensate them for unamortized equipment and staff, then you should be able to negotiate the superfluous breakage penalty down to zero. This is becoming the norm for convenience termination, and the more mature service providers are accepting this contract structure.
10. Client references. Finally, keep in mind that service providers can be more confident in their capability than their performance warrants. And that’s why a proven solution — one that’s attested to by several clients — is one of the most important differentiators. One large pharmaceutical company, for example, was considering several providers, all of whom scored dead even on the financial and commercial terms. So the company sought testimonials from the providers’ other customers, and these became the deciding factor. The customers revealed that one provider proved better than the others in implementing a system and walking the walk.
In conclusion, experience matters in outsourcing. A provider may have the lowest price, but the lack of experience needed for long-term delivery can result in disaster down the road. Likewise, a buyer’s lack of experience in evaluating service providers and designing BPO solutions can affect overall success. But by paying careful attention to these top 10 financial differentiators in an outsourcing transaction, you can make better provider choices and begin shaping a successful relationship.
Entry Filed under: Why Outsource?