Beware the Commoditization of IT Outsourcing

Added on Dec 01, 2012 by Stephanie Overby,

"Faster, better, cheaper," the old adage goes. "Pick two." Indeed, in many areas of IT outsourcing, IT leaders have been pushing for faster everything--RFP processes, transition phases, time to ROI--in an effort to cut costs quickly.

But that, says Edward Hansen, partner in the outsourcing practice of Baker & McKenzie, is leading to what he calls the "over-commodization" of IT services. IT leaders say they want more than just lower costs from their IT outsourcing relationships, yet they treat the process no differently than if they were trying to get the best deal on a gross of number two pencils--with disastrous consequences. talked to Hansen about the dangers of treating IT services as a commodity buy, why real outsourcing value is more than the sum of its parts, and how customers and suppliers can approach deal-making more thoughtfully. In what way is the IT outsourcing process over-commoditized?

Edward Hansen: Reasonable people could differ on what makes something a commodity, but I think that a commodity basically has two overarching attributes: First, it has to be something that can be completely described in a contract; and, second, the provider of the item or service is fungible.

Another way of looking at a commodity is that it has an inverse price-to-value relationship. As price increases, value decreases. This is easily thought of in terms of units per dollar spent. If you can get three number two pencils for a dollar, that's a better value than getting two number two pencils for a dollar.

The nice thing about commodity buying is that as long as a buyer can adequately describe its requirements, the buyer can add significant value to its transaction by introducing competition and driving down costs. A commodity buy process can be very efficient.

In large-scale IT projects, this inverse relationship between price and value doesn't always hold. You may very well get increasing value with increased cost. The trick then is to find that point of diminishing returns. This attribute automatically makes it worth paying careful attention to the buy process for these projects.

There are few people who are doing an outsourcing deal who would think that they are conducting a commodity buying process. But on closer inspection you often find that the buyer is actually just breaking up a complex transaction into a several individual commodity transactions. The units of exchange may differ, but the analysis holds.

So in a competitive process you may see complex scoring models on such things as costs, time to transition or service levels. Once the negotiations are complete, a scorecard can be generated that purports to weigh the individual terms, producing leading and trailing bidders. If the process is taken further, you may even have parallel contract negotiations designed to leverage the terms from one negotiation against another.

This is appealing since it breaks the deal into manageable chunks and provides what appears to be a solid foundation for decision making. So in the end, a "savvy" buyer can look at the cost, review the scorecard, and make a decision. What's wrong with that?

Hansen: Deals have been done this way for decades and we know that it just doesn't lead to a high level of either customer or vendor satisfaction. Yet, in many cases, the parties often have contracts that adequately describe the requirements and resulting solution and contain all the service levels required for that solution to function as agreed, and the parties are complying with the contract.

The problem is that a deal that requires internal change to succeed is not easily evaluated by looking at a simple sum of its parts. In outsourcing, the unit of exchange is often not tangible. Value, as opposed to a unit of product, doesn't lend itself to a unit per dollar spent without getting into economics that take into account other units of exchange that may work in academic settings, but are rarely if ever applied in the real world. To complicate this a little further, requirements in outsourcing are often more elusive than the parties may realize.

Over the years we see several common causes for this, including these:

The presence of shadow requirements that are unspoken or poorly understood and are never meaningfully vetted during the buy process--think innovation, partnership, proactivity

A pricing model that supports the stated requirements, but stops the vendor from satisfying those shadow requirements

Overly complex or self-defeating services levels that lead to unintended consequences

Reliance on a contract to overcome bad deal economics

Failure to form the high-performing teams necessary to carry the deal through transition

Poor governance that fails to encourage the parties to remain aligned

Choosing the wrong partner

The first thing that should come to mind when looking at this list is that these flaws would be difficult to detect in a commodity buying process. And having a "compete on the components" mentality often over-leverages the buyer, which, in turn, can lead customers to get their outsourcers to overcommit. This may make for a good contract, but not a good deal, easily leading to a death spiral where the customer seeks to enforce a contract that was destined to fail. But CIOs are adamant about the need to derive business value--not just cost-cutting--from their outsourcing relationships. How did we get here?

Hansen: It's one thing to talk about value, and another to sponsor a process that actually produces it. There's an old adage that roughly holds: nobody ever wants to spend the ten dollars and a week to do something right, but they're always willing to spend the 100 dollars and years to slog through it once it's done wrong.

It's reasonable to think that a faster buy process will start to yield business value faster, since all the benefits of the deal can start earlier. But this is only true if the time line ends at steady state instead of contract signing. The overriding buy goal should be to get to steady state as quickly as possible without destroying the customer's change management program. This means making it through transition intact, which is almost always more difficult than it sounds, and most buy processes don't support this kind of success.

There has been historical failure on the part of the industry--on all sides--to realize and then take action on the basic flaws in the outsourcing economic model (the elements of the relationship that drive behaviors). This has led to brute force behavioral corrections---SLA credits, contracts that go on for thousands of pages, and so on--but has often neglected the most important elements for success. Yet, when we fail to spend the time and effort to get this right, we have to rely on behavior modification through a contract, rather than the natural alignment of business interests to make a deal work.

Many in the industry are starting to come around to thinking about these deals differently. But while the thinking is getting better, we're in a rapidly changing environment where constant good thinking needs to happen to really drive the value in these deals.

And in the middle of all of this, we are starting to see a push to commoditize the advisors who will most likely fuel this thinking and drive positive change in this area. So at a time when the industry should be converging around unlocking value, the thought-leading advisors should be in a position to help their clients do very well.

This will happen as long as the value proposition that the advisor brings is taken into account when weighing his or her costs. Otherwise, the folks who are best positioned to help unlock that value will be commoditized and forced out of the industry by the very people who should be benefiting from their expertise. So how does this over-commodization of the whole outsourcing decision process play out?

Hansen: On the subject of commoditizing advisors, one example that stands out involved a very good advisor who was competed on costs and speed to contract when the client retained them. In order to secure the client's business, the advisor had to commit to a rigid time frame for RFP generation, vendor meetings, proposal evaluations, and down selection. This deal involved outsourcing for cost containment, but also to support a new global technology infrastructure, process consolidation, and other significant changes.

There were two signs of trouble right off the bat.

The client clearly envisioned using a commodity buying process, which was the first mistake. When you have a deal whose success requires as much internal change as this one did, it is not even close to commodity. The client then evaluated advisors on the basis of which one could run this process the fastest and at the lowest cost. Not only did the client misunderstand the nature of what it was buying, it compounded the problem by hiring an advisor based on cost and speed.

The process played out as predicted. In the middle of a very constructive, iterative RFP process, the deadline for vendor selection expired. The client, fully supported by the advisor who was not in a position to push back at that point, down-selected to a provider that was not yet fully vetted on a set of requirements that were being refined as the RFP process was progressing.

The vetting and deal-making process then had to continue into the contract negotiation phase, which is not the best place for it. The solutioning and contracting process both slowed down, blowing the date for transition start by several months and costing much more in unrealized value than the comparatively small savings in transaction costs. That drama played out before the transition even began. What sorts of problems can a commodity-like buying process cause during the course of the relationship?

Hansen: A few years ago, I had a new client who was a long-term customer of a particular outsourcing provider. They had solid green SLAs and a well-drafted agreement, but they were unhappy. The reason was lack of innovation and partnership.

Viewing this relationship through the commodity lens, it was a tremendous success. The services that could be fully described in a contract were, and for those services it didn't really matter who the provider was.

But one could argue that the real value of doing a capital "O" outsourcing is not in the ability to get the commodity work done, but rather in having a relationship with a strategic partner who is involved in your day-to-day activities. That's what this client was really after, and that's what the provider was really after. But the contract and pricing model did not support that type of relationship.

The governance structure needed to be reworked to allow the provider to learn about solutioning opportunities based on corporate strategy. The pricing schedule also needed to be reworked so that the economics of the deal supported delivering innovation. Without that rework, the pricing of the deal actually penalized the provider for innovation and efficiency.

Interestingly, even in a long-term relationship where the parties were serious about solving this problem, the first reaction from both the customer and the provider was to develop contract clauses and SLAs to drive the desired behavior. Yet, what this really required was an economic and governance solution, coupled with some contract changes, to keep it out of the way of the desired behaviors. What are the opportunity costs associated with too much commoditization in outsourcing deals?

Hansen: The opportunity costs can be huge. There are some experts who believe that two-thirds of the value of the outsourcing market is currently not being realized by either side.

Just something as simple as poor vendor selection has a huge impact. On the surface poor vendor selection requires the parties to use the contract to power through an unnatural relationship. This results in inordinate amounts of contract management energy and frequent failure.

Additionally, this situation is often the result of a buyer who over-reaches in requirements during the vendor selection process, putting the vendor into a must-fail situation that usually starts to surface during transition.

A failed transition will have a multiplier effect on organizational change that is almost immeasurable. Most TCO analyses make assumptions on adoption, but to realize those adoption assumptions users will typically require something predictable to change to - - and that is where transition failure exacts a huge toll.

You can build all of the monetary incentives you want into the contract, but it's the quality of the team that emerges from the contract negotiations that will determine whether the outsourcing gets through transition in one piece.

Once transition is a mess, any other internal change that needs to happen becomes very difficult because the change enabler (the outsourcing provider or the outsourcing itself) will lack credibility with the business. Forget about innovation, transformation, or even realizing your original adoption schedule. How should CIOs approach the buying process?

Hansen: Thinking about the buy process strategically helps. Aside from the obvious, there are two real benefits to a good buy process that are often overlooked. The first is that a strong contracting process can and should be an important pillar to a company's change management process; the second is the ability to form a high performing team that can nimbly navigate transition.

Both of these benefits start with how a buyer approaches the RFP. From an adoption standpoint, getting strong participation in drafting the RFP can help align the internal players and create ownership in a process that would otherwise be imposed on those players. Resisting the temptation to outsource the outsourcing process by engaging advisors or lawyers who just push forms goes a long way here. Expertly vetting the RFP requirements will also help get to some of those shadow requirements that may not be clearly stated otherwise.

It is also helpful to have stakeholders give a view that goes across their own subject matter expertise. Often one stakeholder is the customer of another stakeholder and taking the blinders off can give some insight into how that service should be delivered.

Thinking of the rest of the process as a learning experience and a laboratory for how the execution of the deal will work rather than a chance to eliminate providers is also very helpful. You can still down select in a timely manner, but leveraging the solution expertise that is inherent in the sales process can help get those requirements redefined to maximize deal value. And seeing how your potential provider solves problems with you is a more useful test than setting up a process that really just tests the suppliers' ability to win in a competitive process.

Customers need to rethink their timelines and balance them against the probability of realizing expected deal value.