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?
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.
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.
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.
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.
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.
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.
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.
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.
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 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.
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