Iron-clad outsourcing

Feature

posted 5 Oct 2004 in Volume 1 Issue 4

It’s an option that hasn’t diminished in popularity, but how do you prepare to outsource a service? As Angela Cha, partner specialising in IT and outsourcing law at the London offices of international law firm Masons, explains, getting a clearly delineated agreement in writing helps prepare for every eventuality.

While reducing costs continues to be a major influence, other factors are increasingly swaying decisions to outsource. These include access to innovation, increased speed to market and service quality. But while the value of outsourcing transactions has increased, so have the range of services being shopped outside the business.

Most non-core services that organisations have traditionally provided internally, such as finance and accounting, HR, and property management, are now commonly outsourced.

IT is not exempt from this trend. An August 2004 report from technology analysts Forrester Research1 says that by 2015, 1.2 million European IT and services jobs will be displaced offshore. The report also predicts the UK will lead this move offshore.

The report says that by 2015, 150,000 pure IT jobs will move offshore and 100,000 IT-oriented clerical staff in jobs such as data entry will go. The report also predicts 74,000 European managers in the general-management category will lose their jobs to offshore activity between now and 2015.

So, while the popularity of outsourcing only seems to be growing, there are still enterprises that are in danger of not latching on to the trend. Yet if the Forrester report provides any impetus for businesses to re-evaluate what IT, or any other type of outsourcing, could accomplish for them, they will need to be aware of the potential pitfalls that await them. What follows are suggestions that could help you avoid those obstacles if you’re contemplating any type of outsourcing.

Planning for outsourcing

Outsourcing disasters are reported frequently, but the majority of outsourcing deals are successful and rarely get the same coverage. Like any commercial transaction, outsourcings can go wrong but the mistakes that contribute to their failures can be avoided.

It is self-evident that customers who have a clear idea of their strategic and tactical objectives in approaching an outsourcing project have a better chance of success. They have the ability to communicate those objectives to the service provider and to use them as a contractual basis for their relationship.

They can also use the objectives as a management tool for ensuring both parties to the relationship stay on track.

Having determined the objectives, it’s prudent to test whether they are achievable in the marketplace. A key factor in eliciting and assessing proposals is to have a clear idea of the starting position. This means having an in-depth understanding of the extent and capabilities of the internal functions to be outsourced, the standards of service that they supply and their running costs. Assembling this information can often be one of the most difficult tasks in an outsourcing project, particularly when the internal function is widely distributed across the customer organisation.

Businesses should also consider what form of organisation is best placed to meet their objectives. Should they use a single provider or seek multiple providers for specialist services? Should it require multiple providers to form a joint venture or consortium? Is there any benefit to the customer itself entering into a joint venture with a service provider because it may minimise VAT exposure or create the opportunity to service other third parties? Does it need to outsource at all or could a reorganisation of its internal function achieve the same objectives over time?

Defining the relationship

Given the potential pitfalls involved in any outsourcing, there is a clear need for the terms of the relationship between the parties to be as definitive as possible. Detailed specifications of the parties’ respective responsibilities and liabilities are essential.

The contract should define the precise scope of the services to be delivered, including the service levels. Ideally these areas should be covered in detailed schedules, so neither side can be in doubt as to what is required of the service provider. In practice, obtaining the necessary level of clarity can prove difficult, but it is in the customer’s interest to persevere. General statements of responsibility that don’t describe the services in detail are likely to result in disagreements about scope and pricing at a later date.

Distinguishing services to be delivered by the service provider from those activities that are to remain the responsibility of the customer (or a third-party supplier) is also essential. It defines the boundaries of responsibility in the event of service problems. The ideal situation from the customer’s point of view is that one person – the service provider or, if more than one, the key service provider – should have responsibility for ensuring delivery of the end-to-end service in the agreed manner. However, it is rare for the service provider not to be reliant on performance of certain tasks by the customer, like providing information or the conduct of tests. If the service provider is to undertake end-to-end responsibility, there needs to be a mechanism for granting some measure of relief if the customer fails to deliver.

Service levels and management and reporting of service performance

All customers require a service that is reliable and consistently meets pre-agreed standards. In many outsourcing deals, the customer will expect two contrary movements to occur simultaneously: the quality of services delivered by the provider to improve over time and the charges payable for those services to decrease over time. The challenge is to devise a mechanism that adequately specifies and measures current performance while allowing for that performance to improve over time.

The most obvious and useful way to manage a service provider is through the use of service-level agreements. By agreeing with the service provider on a particular service level, the customer can plan to that level of performance. The usefulness of the measures within a service-level agreement can be diluted by measuring the wrong things and measuring too many things.

As a general rule, businesses should only measure the performance of their service providers in areas where poor performance would have a significant impact. Measuring anything else is overkill and wastes management time on both sides. Performance standards should generally be set in terms of service requirements rather than methods of service delivery. The provider should be pro-active in looking for new and better ways of providing services and should be encouraged to adopt innovative approaches to service delivery. At the same time, current performance should not be sacrificed to the promise of future improvement. Service levels should be challenging but achievable, while being able to deliver benefits to the customer’s business.

Service levels must also be easily measurable. The customer must retain sufficient focus on the management of the outsourcing to ensure service performance is monitored on a regular basis and the service provider identifies and corrects any deficiencies. Appropriate remedies for the different levels of service failure and non-performance must be clearly reflected in the contract.

Successful outsourcing also requires processes and procedures for managing the relationship between the customer and the service provider. In addition to setting service levels and measuring service performance, the parties should agree on regular service meetings, processes for reviewing the services (preferably involving benchmarking provision against other service providers), reporting procedures and a robust mechanism for escalating and resolving problems.

Outsourcing term and exit

Outsourcing contracts run for varying lengths of time. Research carried out by Templeton College found that relatively short-term contracts achieved success more often than longer-term contracts. This is partly because customers cannot realistically predict their requirements too far in advance.

Each business must make decisions on the basis of its needs and the service provider’s financial proposals. However, where the service provider is expected to transform the way services are provided, businesses will rarely be willing to pay the whole cost of transformation at the time it is incurred. They will expect the service provider to recover the investment through the service charges over time, which is unlikely to be achievable in shorter-contract terms. Also, negotiating an outsourcing transaction is expensive in terms of time and resources. A customer who opts for a shorter contract must factor into the financial equation the cost of re-letting the contract at regular intervals. These factors may explain why, particularly in larger outsourcings, contracts of five, seven and ten years are common.

Ensure that you provide for the future.

As the customer, you have an interest in ensuring the services can be transferred seamlessly back to you or to another service provider at the end of the outsourcing. Also, prepare and agree on an orderly service-transfer procedure at the pre-contract stage and during contract negotiation. This will give you assurance that you are not locked into one service provider and that termination is a practical option.

Employment issues affecting outsourcings

Where an outsourcing includes the transfer of staff, it’s likely the 1981 Transfer of Undertakings Regulations (TUPE) will apply. The contract must include the appropriate warranties and indemnities in relation to the parties’ liability for the transferred staff prior to the transfer, post transfer and on exit. The UK and European courts continue to provide inconsistent decisions on whether TUPE applies to outsourcing transactions. TUPE has been held to apply even where no assets or employees transfer. The remedy is to deal with the uncertainties contractually and by using deeming provisions to provide practical certainty.

Lessons learnt

Outsourcings generally fail for a few reasons:

Failure to assess benefits and risks of outsourcing in the light of strategic and tactical objectives;
Failure to agree on appropriate terms and lack of commitment and cultural compatibility on each side;
Expect the unexpected. Any outsourcing contract intended to last for more than a year or two needs to be able to cope with unforeseen changes with the customer, the service provider and the surrounding business environment.

Conclusions

Outsourcing remains popular and shows no sign of decreasing in prominence. But to get the best from outsourcing, businesses have to:

Have clear objectives;
Choose the service provider who can best promote those objectives;
Negotiate a contract that supports the objectives and allows their achievement to be managed;
Devote sufficient management resources to ensuring that both parties stay on course.

Outsourcing is a useful business tool but is not a universal panacea for business problems. Standard approaches can be adapted to many situations. But only proper consideration, negotiation and drafting of all key principles can produce a solid foundation for any outsourcing relationship. Businesses new to outsourcing will see the issues to be considered are varied. Early identification and prioritisation of the major issues is particularly important.

Reference

1. ‘Two-Speed Europe: Why One Million Jobs Will Move Offshore’, http://www.forrester.com/Research/Document/Excerpt/0,7211,35212,00.html