If you are reading this article then it probably means
you have a relationship with an
outsourcing supplier
or are about to create or redefine such a relationship. You may
well have read all about the benefits of outsourcing, as well as
about the pitfalls and disaster stories.
You know it is a tough process. You are going to end up
negotiating or renegotiating a contract so you will need lawyers,
and the HR issues associated with staff transfer and offshoring
options create their own complications.
Your technical architects are entrenched around their favoured
products, the users continue to rely on your service and your chief
executives are looking for further contributions. And by now you
have come across the thorny issues surrounding supplier
relationships.
One basic fact often gets ignored in the midst of all this,
sometimes with disastrous consequences: IT outsourcing is a two-way
transaction. You are selling your capabilities and assets to the
supplier and the supplier is selling their expertise and services
back to you.
Outsourcing is a marriage between a delegation process and a
services contract. Too many transactions end up focused solely on
the services contract side of the equation.
The consequence is that as the process unfolds towards the final
negotiations you, the user, sense unwillingness by the supplier to
behave like a company that is trying to sell you their product.
This in turn can develop into adversarial negotiations, with the
truly catastrophic possibility that the deal will be signed against
an uncooperative, mistrustful backdrop, which may take years to
resolve.
Now consider best practice in negotiation. The common wisdom is
to avoid an adversarial, position-based negotiation and try instead
to aim for a more collaborative approach. The key principle that
underpins collaborative negotiation is to understand the other
party’s objectives.
With this in mind, it is surprising that many users barely
consider what motivates an outsourcing supplier, and so fail to
appreciate their own value in an outsourcing deal.
So what does motivate an outsourcing supplier? Above all, the
supplier is in business, and their business is to make money from
providing IT or business-
process services. It is not about chasing some abstract idea of
creating sophisticated, integrated systems, or efficiency for
efficiency’s sake. Sophistication, elegance, integration and
efficiency exist to serve a purpose: to drive down the cost of
services.
This is commerce, not art or science. Even if the deal starts
with technical discussions, it will end with very commercially
oriented solutions, which will be based on economic objectives.
Understanding the factors that underpin how a supplier will value a
deal is crucial to good negotiation.
So, what are the factors, and what can you bring to the
deal?
Growth potential
Suppliers have to grow. They cannot afford to stand still. Every
deal that a supplier signs represents growth, of revenue certainly,
and probably staff too. A supplier failing to renegotiate means
potential growth is lost.
Remember, you are selling growth to the supplier, you do not have
to give it to them. This is your key contribution in the deal. A
corollary to this is that the bigger the supplier, the bigger the
deal they need to sustain their growth. This means that the largest
suppliers need annual growth on a scale equivalent to the entire
revenue stream of a small supplier.
Revenue and backlog
The primary growth you are providing to your supplier is through
paying service charges, which equates to revenue for the supplier.
This can be interpreted in two slightly different ways: either as
the annualised “run rate” and backlog, or as the total contract
value, which is the sum of the annual run rates for the defined
period of the contract.
Total contract value is a consequence of the average annual run
rate and the period of the contract. So, while the general advice
is to avoid long deals – about 10 years is long in this context –
do not undervalue the negotiating strength that offering a long
contract may afford. It may be enough to win that one last
concession you require.
Profitability and margin
Outsourcing contracts tend to be high-value, low-margin deals.
It is unlikely that your single deal can grow the supplier’s
overall margin. But a single, risk-laden deal can create a
significant overall margin dilution. As a result, this parameter is
more likely to be present in the form of a hurdle rate that must be
met or surpassed.
One of the most crucial internal calculations the supplier will
make, and one of their most carefully guarded figures, will be the
forecast margin for your potential deal.
Too much user focus on the commodity aspects of the deal and
failure to include value-added projects where higher value
resources are used will significantly restrict the perceived value
of the deal you are selling to the supplier.
Cashflow potential
A low-margin, high-turnover business will be cashflow sensitive.
Therefore, any contractual discussions about withheld payments,
service credits or liquidated damages – with their parallel impact
on profit margin – will be treated with more fear than you may
initially imagine.
This does not mean that these terms are necessarily
unreasonable, just understand and expect the objections you are
likely to encounter.
Market share
Suppliers have a growth strategy based on geography and vertical
segment. You may consider a supplier weak if they do not have
credentials in your geographical region or vertical segment. But
for them, your deal and the market presence that you bring to the
table may be a springboard for their growth.
Of course, the exact opposite may also be true: you may actually
be looking at a market that the supplier genuinely has no interest
in developing.
Hardware assets
In days gone by, hardware assets tended to be well received by
suppliers. They were usually valued at net book value or fair
market value, the intent being to introduce automated-systems
management, consolidation and leveraging of the assets across
multiple deals, disposing without loss of those that became surplus
to requirements.
The cash injection into the user was also welcomed.
Generally, this approach is no longer used – with the exception
of systems management – and hardware assets nowadays tend to be
treated on a lease basis when they are transferred. This makes the
financial case for transfer somewhat less interesting than it once
was.
As a more general point, outsourcing suppliers do not typically
make the best finance houses, although some have financing
arms.
HR assets (staff)
Staff assets can be seen in the same analytical light as
hardware, and the end result is often similar; systems automation
replaces some staff, while others are offshored.
Scarce resources are leveraged by suppliers in the early stages of
growth, the idea being that they acquire their skilled staffed from
you. With the advent of a more commoditised approach and widespread
offshoring, this too has less impact than it once did.
Facilities assets
The group of business assets that potentially still retain some
interest to suppliers are facilities such as datacentres and call
centres, especially if they are offshore.
Software assets
Licensed software assets may be a source of cost consolidation
for a supplier. This is because the software owner may allow them
to aggregate licences.
If this is not the case, such assets have little value. Software
developed in-house, often incorporating reusable IP, will only be
of interest if joint go-to-market is an option. These ventures
have often yielded poorer results than forecast.
Systems assets
The scope of this type of deal creates a lot of interest from
suppliers, particularly where development or project work – which
typically carries a high margin – is included. Equally, suppliers
that are also hardware manufacturers like to assure sales of their
product, as do software suppliers.
It is interesting to see how suppliers that also provide
hardware and software are moving into outsourcing, despite the
lower margins, in order to protect their financial base.
Target revenues
Different suppliers account for target revenues – the numbers
that drive a team’s sales bonuses – in different ways. Some measure
a win by total contract value, some by first-year revenue, some by
the portion of first-year revenue within the current financial
year.
If you are negotiating a deal in the 11th month of the
supplier’s financial year then teams using either of the first two
revenue measures are likely to be keen to sign before the year
ends. Teams using the third measuring system may well wish to delay
until the first day of the new financial year.
Sales bandwidth
Suppliers typically maintain an outsourcing sales team with a
fixed headcount, expenses budget and revenue target. Assuming your
proposed deal matches the supplier’s market, the level of interest
may determine the quality of team that they assign to the pursuit;
not all teams are equally effective. This dynamic will affect your
negotiations.
Risk factors
Risk is a set of considerations that counterbalance the
potential positives listed above. And there is one aspect of risk
that does not necessarily have a positive counterbalance:
operational delivery.
The “business as usual” operation that the supplier takes over
is full of unknown risks. Experience will allow the supplier to
reasonably assess such risks, but risk very often deals with an
element of the unknown.
With operational risk, or rather, operational failure, comes the
possibility of all the other major commercial risks. These include
withheld payments and margin erosion as a result of cost of
remediation.
Hard-nosed suppliers have to view signing a new deal as signing
up for new risk, and the process of managing service delivery
includes a substantial portion of risk management.
Along with forecasting costs and offering a price – the factors
that form the positive basis of forecasting profitability – comes
risk assessment, which will indicate the potential loss in the case
of failure.
This assessment generates the most complex dimension of the
proposed transaction. For the bigger the transformation required,
the more pressing the need to enter new markets, and so the greater
the risk becomes.
Sales cycles
As a user, you need to be aware that the supplier’s sales cycle
will tend to move from a positive sales-oriented position to a more
cautious, commercially risk-oriented position over the course of
the deal-making process.
This waveform will usually hit its nadir as contract
negotiations are fully engaged. Each term negotiated exposes
another element of risk, and strong negotiation by users pushes a
keen outsourcing supplier deep into risk territory.
Presenting a supplier with more and more risk as a one-sided
transaction is seldom a good strategy, although it can be done in
the right circumstances. It is no exaggeration to say that there
have been internal supplier announcements that begin, “The bad news
is that we won the deal…”
Suppliers are first and foremost commercial animals, and risk is
an inherent part of commerce. A supplier that actively manages its
risk should be seen as a positive, because your success will
inevitably become linked with theirs.
Indeed, a supplier that appears cavalier with risk should be
viewed with caution. Although your contract may look fine, what
about the next one they sign, which may break their company, and
damage your standing in the process?
The final ingredient
To summarise, the “out” part of “outsourcing” denotes a fairly
unique transaction. It means a sale and transfer of assets,
processes and capability to deliver services linked to a reciprocal
agreement to purchase similar services over an agreed period of
time.
You are selling a revenue stream alongside the means to deliver
it, and you are committing to buy services. The supplier is
committing their expertise to deliver improved services at better
value, and is purchasing capabilities as well as risk.
You and the supplier have differing aims and capabilities, but you
are not simply a user in any conventional sense. You are an equal
partner in the transaction.
Mutual benefits result from an open understanding and acceptance
of each other’s objectives, along with the confidence and respect
to behave like a partner. Shared losses can easily arise when
negotiations become position-based and adversarial due to a lack of
understanding, or when the significance of risk is under-valued,
typically by the user.
Achieving a balanced, productive relationship between supplier
and user is the final ingredient required for successful
outsourcing.
l Andy Treder is a managing consultant at outsourcing advisory
firm Alsbridge
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