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Balancing Power in Outsource Contract Agreements

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The practice of outsourcing business processes has long been subject to the discussion how best to ensure optimal benefits for both parties involved in the outsource agreement.

In conventional outsource agreements conflict often arises between the objective to minimize cost and the necessity to continually develop the service. This leads to unsatisfactory results for both parties. However, conflicts can be resolved by increasing the collaboration between both parties to a level where the service provider is considered a vital part of the purchasing company. This “annex” arrangement offers on-going and exclusive access to a customized service from the service provider in return for the advantages of a long-term contract granted by the service purchaser.

Traditionally, a service provider will argue in favor of a long-term outsourcing contract while the purchaser will often opt for short term agreements. This allows the purchaser the possibility of sourcing more effective competitive services. Purchasers often believe this approach keeps the providers “on their toes” and ensures the best level of service, at the best price. This may be so in the short-term, but the service provider, having no guarantee of continued business, will be less motivated to undertake long term investments developing their service particular to that one client. Instead, the provider will concentrate on the safety net of being able to offer their service to the market in general.

Considering the service provider an “annex” to the purchasing company can solve this power struggle to the benefit of both parties, but it necessitates a change of approach in many cases: although most companies claim that the reason for considering an outsource is strategic, the reality is often that the decision is purely financial, based on a calculated cost reduction. Annexing is only possible where the purchaser genuinely seeks to gain competitive advantage through competence or capability of service, as opposed to simply achieving an immediate lower cost.

In this form of outsourcing, the service purchaser must choose a service partner who can sustain a long term delivery of service that continues to be more effective than a possible in-house alternative. In addition, and equally important, this service must remain superior to the provider’s competitors. Winning the beauty contest today is good and well – but could the beauty fade with time? To ensure continued competitiveness, a number of measures can be taken that will lead to a partnership in which the purchaser finances its own superior position in the market, rather than buying a mere commodity service.

Close Collaboration

While many outsource dealings are conducted at arms length, and on a contentious basis, annexing relies on close long-term collaboration, or partnership. Collaboration between purchaser and service provider is not a new concept in outsourcing, but annexing takes it to a new level by treating the service provider as an internal entity. Still the purchaser shouldn’t forget that the service provider (in most cases) knows its own business best and should be entrusted to conduct its own affairs accordingly, without unnecessary control or interference. Both parties must be confident that they are pulling in the same direction, and this necessitates free flow of information between the two partners, openly and without reservation on both the short and long term, on all aspects of the business.

Funding Investment

By entering into an annexing arrangement with a service provider, the purchaser must also rethink the financial objectives. Typically cost of service is a strongly negotiated factor, with both parties understandably looking for the best deal. However, with an annexing agreement, achieving the lowest cost or charge for the service may not benefit either party in the long run; it is worth keeping in mind that in an annex arrangement, the poor financial health of one partner can adversely affect the health of the other. By entering into contract at a cost which is too low, the service provider will be unable to realize a sufficient profit margin to allow for reinvestment in the further development of the service. Although, at the outset, the purchasing company may obtain a financial benefit from this situation, the benefit will be quickly lost as the provider’s competences and capabilities diminish, and the service level consequently drops to a problematic level. Once at this stage, many service purchasers simply discard the provider and look to the competition in order to attain a better service. However, this constant change of provider means that a truly optimized solution is seldom achieved.

To resolve this issue, a more transparent approach to costing must be taken. The cost-plus method, where the purchaser agrees to pay the operating costs incurred by the service provider, plus a percentage – which is taken as profit – is particularly suited for annexing agreements. This calculation forms the baseline price of service, typically set at unit level. To ensure continued competitiveness, an amount must be dialed in on top of operating cost and profit to finance continued investment. As discussed earlier, sufficient funding must be available to the provider in order to allow them to continue research and development on their service. It is the responsibility of the service provider to identify these opportunities for further improvement in the service, and it is also their responsibility to prepare a business case detailing the cost and benefit of any investment. Again, the service provider must act like any other internal department and go through the appropriate channels in order to procure the additional funding from the purchaser.

Evolving Service Level Agreements

Another point to consider when entering into an annexing agreement is the Service Level Agreement (SLA). The SLA is the mechanism by which expectations are contractually managed - the service provider is explicitly aware of what they must deliver, and the purchaser is explicitly aware of what they must accept and pay for. Due to anticipated and continued development of the service over time, along with expected changes in dynamics in the partnership, it is necessary for the SLA to be built with evolution in mind. After all, it is unlikely that the SLA applicable today will still be fully applicable several years into the contract. It is the responsibility of the purchaser to set ever challenging expectations from the provider. As soon as one service improvement has been realized, the relevant SLA must take this new capability into account, and “raise the bar” further. This ensures that the service provider is being constantly challenged to come up with more effective ways to do business and stay ahead of the competition – the source of the purchaser’s competitive advantage.

Two-way exclusivity

Exclusivity, naturally perceived as a danger by the purchaser in a traditional service agreement, works both ways in this type of outsourcing contract. While annexing means heavy reliance on the long-term partnership with one selected provider, the purchaser also requires that the provider must provide exclusively to them. This mechanism protects the investment that the purchaser places in the provider and ensures that the corresponding competitive advantage remains out of reach of competitors.

Through annexing, the exclusive collaboration coupled with ongoing investment in service development increases both parties’ competitive position. When this is controlled by evolving service level agreements, the parties to the long term outsource contract can both finally deal from a position of equal power.

© GA Advisory 2005

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