Check out the supplier before taking the outsourcing plunge

Pressure to save cash is leading companies to take on outsourcing contracts that make little allowance for a future need to...

Pressure to save cash is leading companies to take on outsourcing contracts that make little allowance for a future need to change. Last week's expensive ending of the IBM/Halifax Bank of Scotland deal is an example of how initial promise is hard to fulfil. Nick Huber reports

Last week's termination of a £700m IT outsourcing contract by the Halifax Bank of Scotland (HBos) did more than raise further question marks over the merits of so called "mega deals".

With companies eager to hand over to suppliers swathes of their software, hardware and IT staff, the outsourcing market is going from strength to strength. Deals worth hundreds of millions of pounds and stretching over five to 10 years have become commonplace, particularly in the financial services sector, as suppliers push outsourcing as a way to slash IT costs for the user.

Meanwhile, however, the list of failed high-profile outsourcing deals continues to grow; the HBos-IBM deal was just the latest casualty.

So what steps can IT managers take to allow an outsourcing deal to cope with changing circumstances? And how can they judge the different suppliers in the market?

Guidance for choosing an outsourcing provider is largely common sense; the same rules of thumb apply when choosing any kind of supplier.

"[There should be] confidence that the IT supplier can do the job in the right time and to the right quality," said Anthony Miller, a research manager at analyst firm Ovum Holway.

For example, ask a supplier to provide examples of customers in a similar industry, to gauge the experience of the supplier, and their strengths and weaknesses in particular markets.

The more tricky task when attempting to negotiate a durable deal is ensuring that the contract is flexible enough to change with the business needs of the user, for instance if it merges with another company.

Lack of flexibility is the main reason why outsourcing contracts break down, according to experts. "Flexibility [in] a contract is very difficult as you can get caught up in a paralysis by trying to predict every possibility," said Miller.

"You have to allow for supplier- and customer-based change. There has to be enough trust for the supplier and customer to agree that they did not quite allow for something to happen [during the course of the contract] but to still come to an agreement on it."

One increasingly popular framework to cement this trust is so-called risk-and-reward outsourcing contracts. As the phrase suggests, such contracts involve both user and supplier sharing the risks and rewards during the lifetime of the contract.

This touchy-feely partnership approach has obvious attractions to both sides, but again it has had only limited success in practice, according to industry analysts.

They argue that users normally want to minimise the rewards paid to the supplier - say, extra money for performance above the agreed services levels in the contract - while suppliers want to cap the risks they are taking.

Also, measuring the performance of the outsourcer in a risk-reward contract can be difficult. While judging the performance of the supplier on the volume of transactions processed, linking the performance of the supplier to the profits of the company is more convoluted because so many factors influence a company's profits.

According to Philip Morris, a director at outsourcing advisory firm Morgan Chambers, most companies do not even bother to track in detail exactly how much an outsourcing supplier is saving the company each year once the deal has been signed.

"Very few companies track and collect benefits once the deal has been struck. A company needs someone who is ultimately responsible for IT to answer to the board for the return on investment on the deal," Morris said.

A desire among companies to drive down costs is the dominant reason for most outsourcing deals at the moment, however. When the deal is announced users will proudly boast how much the deal will save them in projected IT costs - often about 5% of the contract's value.

Most of the time, however, these predictions are worthless, according to outsourcing experts.

This is due to two factors. The structure and needs of the user's business are likely to change significantly during the five- or 10-year contract, demanding new services from the supplier which shifts the original cost savings target. This makes any cost savings hard to quantify.

Also, if an outsourcing contract runs into trouble the customer and outsourcing supplier have a vested interest in keeping the matter private. Conversely, users rarely publicise a successful outsourcing deal for fear that that it will give away a competitive advantage.

Some industry experts claim that users could avoid troubled outsourcing deals by doing some basic research before signing with a supplier. "There is no substitute for a company that is thinking about using an outsourcing supplier than to go and talk to one of the supplier's customers," advised Morris.

But this often does not happen, or when it does the process is rushed, Morris added. When an outsourcing deal is terminated or runs into problems it is important to have a clear exit clause.

Every year companies quietly pay suppliers millions of pounds in penalties for ending a contract early, but this is unfair, according to Morris.

"A supplier should be compensated for any investment made [on behalf of their customer] but suppliers should not expect to be compensated for loss of profit for the remainder of the contract as they have not delivered the service."

It is time, in other words, for users to get tough when negotiating outsourcing deals.

Striking the right deal
  • Do your homework. Do not just check the supplier's reputation, but talk to some of its customers; they will soon tell you about any of the supplier's shortcomings

  • Focus on how easily you can change the contract three years down the line - will the supplier be able to adapt to your needs if you acquire another company?

  • Agree an exit clause that minimises the money you will have to pay your supplier when terminating a contract

  • Do you have a simple criteria to measure the supplier's performance - volume of transactions, project activity etc?

  • Remember that most projected cost savings from an outsourcing deal are wishful thinking. Changes to your business will require new services from the supplier and that changes any predicted cost savings/benefits.

Who are the outsourcing giants?
The outsourcing industry is dominated by IT service giants, such as EDS and IBM, and the consultancy arms of the professional services firms, for instance Accenture, KPMG and PricewaterhouseCoopers.
  • IBM Global Services is one of the leading suppliers for the big-ticket outsourcing deals, which can stretch into billions of dollars. Its biggest customers include travel and real estate giant Cendant Corporation and Astra Zenica. IBM is also strong in the financial services sector but has lost a number of high-profile deals over the past few years (CGNU and Halifax Bank of Scotland) after customers terminated contracts early

  • Texas-based EDS is strong in a wide number of areas, particularly the public sector (the Inland Revenue is one of its high-profile clients).

  • For the public sector Capita and ITNet are big players along with EDS, particularly for local government. Torex and Northgate are strong in the health sector.

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