The
contract had been finalized and needed only the board's approval to
make it official. But on the eve of signing the multibillion-dollar
pact to outsource all of the information technology systems at this
large European bank, the board members threw a wrench into the plans:
They wanted some outside proof that the promised benefits would be
realized.
Good thing they spoke up. An independent consultant then
determined that of the 22% savings the outsourcing vendor had promised,
only 7% was likely to be realized. More shockingly, the review
concluded that if the bank made some internal improvements, it could
achieve 12% savings on its own.
If the push toward outsourcing is keeping executives busy during the
work day, stories like this are agitating them at night. Though deals
to outsource IT functions have become commonplace, a major,
multifunction IT deal can still be challenging. And as companies move
to offload increasingly complex business processes such as financial
forecasting or procurement, they learn, often the hard way, just how
tricky it can be to structure the deals and manage the relationships.
A major, transformational outsourcing deal (say, a plan to outsource
human resources functions to facilitate a company's global growth) is a
transaction like no other. It's a bit like a divestiture, except for
the deep, ongoing connection between company and vendor. It resembles a
joint venture, except that in place of a governance system setting up
general principles and responsibilities, there is likely a very long
contract specifying service levels and addressing multiple
contingencies. Throw in a typical six-month negotiating period and the
potential for misstep when embracing what is, after all, a
controversial business practice, and it's easy to see why many
executives struggle to get these deals right.
"Too many companies think of outsourcing as an ad hoc opportunity,"
says Mark Gottfredson, co-head of Bain & Co.'s global capability
practice and a consultant to that European bank. "They see that another
company in their industry has outsourced IT, for example, so they
decide they are going to outsource their IT as well."
To be sure, some companies have an approach that is anything but ad
hoc. Through multiple outsourcing deals, they've developed know-how and
assigned responsibilities. At Procter & Gamble Co., for example,
the external business development group (see page 14) is also the
company's center of expertise for outsourcing transactions - though
vice president of external business development and global licensing
Jeffrey Weedman quickly points out that his small outsourcing team
plays a supporting role in these deals. The outsourcing COE can assess
what's available in the market and often help with negotiations. But
the company unit doing the outsourcing will put many more people on the
deal, will make the decision - and, of course, will own the
relationship.
At General Motors Corp., a trailblazer in outsourcing now
approaching another major milestone, chief information officer Ralph
Szygenda is leading the activity. GM, of course, farmed out its entire
IT operation in the 1980s as part of its $2.55 billion purchase of
Electronic Data Systems Corp. Having long since divested EDS, GM
recently began exploring its alternatives when EDS' services contract
expires in 2006. Szygenda is leading a group of executives charged with
examining the entire operation and writing requests for proposal that
will go out in early 2005.
Other companies tap an executive from the CFO's office or from the
procurement department to run all sourcing operations. Often, the
corporate development department - the group most experienced at
structuring deals - is asked to play the leading role. "These
transactions are moving from just IT people signing deals to corporate
development officers taking charge," says John K. Halvey, founder of
the technology finance and outsourcing practice group at Milbank,
Tweed, Hadley & McCloy LLP. "Outsourcing is the corporate
transaction of the early 2000s, and the person who is the chief
sourcing officer is emerging as a real corporate power broker."
Clearly, different companies find different solutions. But it's
equally clear many companies simply haven't figured out how to make
outsourcing deals work to their satisfaction. About 80% of the
companies Bain surveyed say they believe they have not gotten the full
potential out of what they have outsourced.
For companies considering farming out business processes to a
third-party vendor, the first question to ask is whether outsourcing is
truly the best option. Often the targets of outsourcing transactions
are areas of a business that have received little, if any, internal
attention for years. Experts in the field say managers must evaluate
what changes are possible without a third-party vendor before asking
for outside help.
"Outsourcing is a tool to an end," says Chris Disher, a vice
president at Booz Allen Hamilton Inc. and a partner at the firm's IT
group. "A company has to figure out what their goal is and look at all
of the different approaches to reaching that goal. Outsourcing is just
one of many approaches."
Understanding whether it is the right approach can take some
corporate soul-searching, says Peter Allen, partner and managing
director at Houston-based sourcing advisory firm TPI Inc. "Probably the
biggest factor influencing whether outsourcing is the right solution is
internal capacity for change," Allen says. "Corporations that can
effect considerable cost improvement on their own don't necessarily
need outsourcing to achieve the objective."
The converse is true as well: The best candidates for outsourcing
are the companies that, for whatever reason, cannot squeeze the extra
costs out of a function, or add the needed capabilities to it, on their
own.
"Outsourcing clients tend to either be desperate because they don't
believe their internal organizations have the capacity to make the
change, or they are ambitious because they don't think they have the
resources to move as fast or as boldly as they want to," Allen says.
"Clearly, if a client could get the savings on their own, they would do
so. To engage a third party implies that a client has come to the
conclusion that they cannot do it themselves."
More and more, change is what outsourcing deals are about. All the
major vendors are trying to ride the trend, seeking out higher-value
business process deals over simple infrastructure deals. So far this
has worked to the advantage of vendors with consulting backgrounds,
especially those once connected with the big accounting firms in the
past (Accenture, BearingPoint Inc., Capgemini) or present (Deloitte
Consulting). Technology company rivals such as Computer Sciences Corp.,
Hewlett-Packard Co. and IBM Global Services obviously won't cede the
territory, though. And Indian vendors such as Tata Enterprises
(Overseas) AG and Wipro Ltd. now offer a wide range of higher-value
solutions as well, though they are still largely known for
commodity-type services.
The deeper relationships raise the stakes on a perennial feature of
outsourcing negotiations: how to get the best possible deal while still
laying the groundwork for a fruitful, long-term collaboration. "It is
important to use the contract talks to start the process of building
the foundation of trust so that the relationship can grow and prosper,"
says Gregg Kirchhoefer, an outsourcing expert at Kirkland & Ellis
LLP in Chicago. "Should you win every point in a negotiation, you might
end up losing the war."
Outsourcing deals are inherently complex. Beyond the typical
protections afforded to parties in M&A deals, companies divesting
and contracting with service providers must carefully lay out issues
including service levels, control rights, the right to in-source and
the right to expand or contract a deal as business needs change.
Worries about what will happen to the level of service as the vendor
absorbs the assets in search of synergies aren't uncommon - though
Gottfredson notes that large clients retain leverage, citing the
example of a vendor with an Indian call center that devotes entire
floors to individual customers.
The goal is to write a contract that considers all possible
foreseeable difficulties, avoiding as much ambiguity as possible.
Consultants say that after a contract takes effect, the service
provider, who now has control of the assets that have been divested,
has considerable leverage in the event of a dispute, potentially
placing the client in a difficult situation.
As part of due diligence, Allen suggests that a company carefully
consider how a service provider expects to derive a profit out of an
outsourcing contract and whether the estimates the vendor uses seem
reasonable. Overly inflated vendor expectations are unlikely to be
realized, a situation that could lead the service provider to cut
corners or demand higher compensation rates.
Companies should also press service providers about contingency
plans. What backups are in place should a locale such as India, for
example, suddenly become more expensive or unavailable for work to be
farmed out, and who would pay for whatever transition needs to be made?
"The last thing you want in these relationships is a sick service
provider," Allen says. "The behavior exhibited by a sick service
provider tends not to be conducive to a good long-term relationship."
Most important, companies need to make sure their entire employee
base is aware of and ready for the changes that an outsourcing deal
brings. Consultants say they urge their clients to focus on
communicating the deal to all employees and to put a top-level
executive in charge of the transaction to coordinate adjustments
throughout the corporation.
Companies that have been through the process say that a good,
experienced vendor should be able to lead the client through a complex
asset transfer. Although the potential customer is typically at a
disadvantage when negotiating a contract - after all, large service
providers such as IBM and Accenture have years of experience doing
these deals - once a contract is signed, the vendor's experience
becomes a plus as it helps the client craft the most efficient way to
complete a transaction.
Usually some overlap time is required, with both the company and its
vendor running systems in parallel. If multiple functions are being
outsourced simultaneously, the complexity of a deal goes up
exponentially, one reason why many companies prefer to do all their
business with just a few big vendors capable of handling more than one
assignment at a time.
The relationship between a company and its vendor varies, based
largely on what a corporation hopes to achieve from outsourcing a unit,
according to Disher. That makes sense: A company with the primary goal
of driving down costs should expect a lower level of service from a
vendor than one that intends to use outsourcing to help it expand the
business or give it additional expertise in a core area.
These relationships, like the business of outsourcing itself, are
evolving. Count on the large vendors to continue to push into new, more
complex, areas for growth and to continue applying new technologies and
efficiencies to revamp older businesses.
For example, the emergence of highly trained engineering talent in
locations such as China and India has invigorated the businesses of
contract engineering and application development, opening opportunities
for companies to cut costs in areas that seemed unlikely targets for
outsourcing just a few years ago.
As the industry matures, the business will transition from relying
on new contracts to companies switching between vendors as existing
contracts expire. Analysts expect these switchovers to be precarious,
given the complexity of transitioning from one third party to another.
Yet, despite the growing complexity, the fundamental axiom guiding
these transactions is unlikely to change: Success in outsourcing
requires a strong vision from the top of a corporation and a
well-thought-out plan for making that vision a reality.
"The message is that outsourcing definitely needs to be a top-down
tool," Allen says. "The CEO and the CFO are the drivers of the business
strategy, and they need to be the ones who make sure the sourcing
strategy reflects that business strategy." - Lou Whiteman
| Large transactions trend upwards ... |
| The
industrywide volume of outsourcing deals with a total contract value of
more than $200 million is exceeding last year's level |
|
Quarter |
No. of contracts |
Total value ($bill.) |
|
1Q02 |
21 |
$16.0 |
|
2Q02 |
21 |
11.4 |
|
3Q02 |
8 |
6.4 |
|
4Q02 |
17 |
21.7 |
|
1Q03 |
19 |
13.1 |
|
2Q03 |
18 |
13.4 |
|
3Q03 |
19 |
12.3 |
|
4Q03 |
25 |
16.4 |
|
1Q04 |
22 |
9.8 |
|
2Q04 |
20 |
15.7 |
|
3Q04 |
16 |
20.1 |
|
|
| ... as BPO deals gain in the broader market |
| Business
process outsourcing deals are gaining on information technology
transactions, as a look at the industrywide volume of deals with total
contract value greater than $50 million shows |
|
Year |
ITO deal volume ($bill.) |
% of industry total BPO contract value |
BPO deal volume ($bill.) |
|
2002 |
$51.6 |
23% |
$15.7 |
|
2003 |
56.0 |
18 |
12.2 |
|
YTD 2004 |
38.9 |
31 |
17.2 |
| |
| Business processes being outsourced |
| YTD 2004, as % of total dollar volume |
| Multiprocess |
36% |
| Financial services operations |
21 |
| CRM |
21 |
| Finance & accounting |
5 |
| Human Resources |
4 |
| Procurement |
3 |
| Other |
10 |
|
|
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