Strategic Outsourcing For Services

Author(s):

Dr. LeRoy H. Graw, C.P.M., CPCM
Dr. LeRoy H. Graw, C.P.M., CPCM, President, National Contract Service Corp., La Crescenta, CA 91214, 818-248-9566.

82nd Annual International Conference Proceedings - 1997 

The Issues. Organizations have traditionally assigned the service contracting responsibility to functional organizations other than purchasing. This "traditional approach" has not always been effective without the business, negotiation, and analytical skills resident in the organization's purchasing and contracting staff.

The Opportunity. In their strategic planning efforts, most organizations are beginning to focus on outsourcing or make-or-buy decisions for the broad scope of services currently being performed in-house. Top management in many of these organizations is beginning to recognize the special skills their purchasing departments can provide to the strategic outsourcing decision-making process.

Objectives. This workshop provides the knowledges needed to make professional purchasers effective member of their organization's "Strategic Outsourcing Team." Specifically, at the completion of the seminar, participants will be able to:

  1. Explain the pre-award (contract formation) and post-award (contract administration) processes unique to service purchasing.
  2. Determine how to establish a viable service outsourcing program in their organizations.
  3. Explain how to become effective members of the "Strategic Outsourcing Team" within their respective organizations.

Pre-award (Contract Formation) Processes.

Funding. Although supply purchases are almost always fully "funded," service purchases often span fiscal or calendar years. Many buying organizations attempt to relate work effort closely to the fiscal year and thus will only "fund" work needed in the current fiscal year. Public sector service buyers normally handle this problem by use of one year renewal options or "Availability of Funds for the Next Fiscal Year" provisions, which tell the service supplier that he/she will have contract work in the next fiscal year only if the necessary funds are appropriated.

Make-Or-Buy/Outsourcing. The NAPM Glossary of Key Purchasing Terms, second edition, defines outsourcing as "a version of the make-or-buy decision in which a firm elects to purchase an item that previously was made in-house; often utilized for services." The AMA Management Handbook provides a definition which is much closer to this article, specifically "outsourcing means having an outside organization supply a service." Formal "make-or-buy" for service purchases is a relatively new phenomenon for most private sector organizations (although most firms in the oil and gas industry have had such programs for a number of years). The Federal Government promulgated its OMB Circular A-76 (Outsourcing decision-making for what the Federal Government considers "Commercial-Industrial Activities") during the Eisenhower administration. Using A-76 as a guide, the U.S. Department of Defense has been the pioneer in conducting the cost-comparison studies which are typically required in making the decision whether to continue a service in-house (using Governmental employees) or to contract out for those services. Most State, County, and Local Governments are relatively new entrants into the outsourcing arena, although the September 1996 Purchasing Today, in the Cherish Karoway article entitled "Outsourcing Helps the Public Sector Pare Down," reports that the Los Angeles County Sheriff's Department has been able to save from 1% to 5% of the $200 million it spends annually on maintenance, repair, and operating services.

Labor Law Issues. Private sector service purchasers have to incorporate fewer labor laws in their solicitations and contracts than those in the public sector, but service solicitations and contracts in general are replete with labor law requirements.

In private sector service purchasing the purchaser must incorporate the requirements of the Contract Work Hours and Safety Standards Act (CWHSSA) in addition to the Fair Labor Standards Act (FLSA).

In the Federal Sector service purchasers must invoke FLSA, the Service Contract Act (SCA), and the Contract Work Hours and Safety Standards Act (the latter act applies primarily to construction-related work). The Service Contract Act places a significant administrative burden on the Federal Purchaser. The Service Contract Act prohibits award of a covered service contract until that contract contains a contract and area-specific wage determination. The Department of Labor (DOL) in Washington, D.C. rarely issues such determinations earlier than 90 days after the date of initial request. The buyer must obtain a new wage determination for each contract extension. In addition, the Service Contract Act permits only direct labor and related costs to be adjusted in a contract extension, thus excluding increases in material, overhead, general and administrative expense (G&A), or profit. In addition, the Federal Sector service purchaser must assist DOL in administration of the law on his/her contract, initiating suspension or debarment procedures, if warranted.

The Federal Sector purchaser of construction services has perhaps the greatest administrative burden of all as he/she must administer Davis-Bacon and related acts for DOL. A full discussion of the pre and post-award responsibilities and duties that Davis-Bacon places on the buyer is beyond the scope of this workshop.

Descriptions Of Requirements. In service purchasing the specifications (typically called "Statements of Work" or "Scopes of Work") tend to be contract-specific and tailored to the circumstances. Statement of work preparation generally requires a technical/contracting team. Because they are often developed under severe time constraints, statements of work may be less comprehensive and clear than supply specifications, particularly if the organization has little experience with similar services. Although it is possible to take the easy way out by asking the service supplier to write the statement of work, such an approach should be strongly discouraged, since it creates a conflict situation when the service supplier wants to bid/offer his services on the procurement. It is almost as bad to have the service purchaser/buyer prepare the statement of work, although the author has found it a common practice in both the private and public sectors. Service purchasers should insist their technical/engineering staff participate actively in the preparation of all statements/scopes of work.

In-House Estimates. It is a good business practice to prepare estimates for all complex purchases, but service purchases frequently require detailed in-house estimates. Service suppliers are quite typically selected based on technical as well as cost criteria, and may involve technical as well as cost negotiations. A detailed in-house estimate (supplemented by a records audit, if appropriate) assists the purchaser in the negotiation process. Construction contracts depend heavily upon detailed estimates, both as a basis for reviewing and verifying bid errors, and as a means of establishing and verifying schedules of prices used in pricing contract changes and making payments.

Solicitation. The highly individualized nature of services and the inability to communicate statement of work requirements on the phone mandate the use of written solicitations for most service contracts.

Contract Types. Whereas the purchaser of supplies can often spend his/her entire career awarding firm-fixed-price and fixed-price-with economic price adjustment/escalation contracts and purchase orders, service purchasers must be adept in using various types of contracts. The indefiniteness of service requirements will frequently make blanket order instruments (like indefinite-quantity-indefinite-delivery, requirements, or time-and-material/labor hour contracts) necessary and appropriate. "Combination" or "composite" contract types may even become necessary, with clearly defined contract services falling under a firm-fixed-price line item and other less clearly defined contract services falling under requirements or time-and-materials line items. Use of firm-fixed-price contracts for all services is courting a contract administration disaster.

Supplier Selection Criteria. Unlike most supply contracts, service purchases will often consider technical approach and experience to be as important as low price. Architect-Engineering firms are generally selected solely on technical qualifications; the contract is awarded after price negotiations with the best qualified firm. Other service purchasers tend to select the supplier based upon submission of both technical and cost proposals, and consider price as only one of several selection criteria. The weight assigned to price may be so low that it has little effect on supplier selection.

Nature Of Service Contract Deliverables. Service purchase deliverables can take many forms. It is good practice to package services into discrete deliverable work units like square feet of wall painted or square meters/yards of lawn mowed. Such work packets can readily be priced either as a "lump-sum" or as a fixed-price line item. If it is impossible to define requirements as discrete work packages, time-and-material or labor-hour line items will suffice. Loaded labor rates (including base hourly rate, benefits, overhead, general and administrative expense (G&A), and profit) can be developed and applied against estimated man-hours. Total dollar estimates for material usage can be added to the total labor estimate to derive a total cost estimate. The output of time-and-material/labor-hour contracts is measured in man-hours, which are less easy to inspect for quality than are discrete work packages.

Post-Award (Contract Administration) Processes.

Ordering. Service purchasing often necessitates the use of contract types which rely heavily upon ordering "as needed." Most blanket order contracts for services involve multiple ordering, adding to the administrative workload.

Inspection Procedures. Services must always be inspected at the performance site, wherever that may be. To ensure rejection of nonconforming or unperformed work, statement of work writers must struggle to include clear, unambiguous inspection procedures and standards of quality in the contract.

Penalties For Non-Conformance. A service, once performed, cannot be "returned to the manufacturer." The purchaser must either insist on reperformance or reduction in price, depending upon what the service as performed is worth to the buying organization.

Contract "Term." In the absence of supplier default, service purchases will generally either terminate at project completion (sometimes years in the future), or be extended at the option of the purchaser.

Renewal options are used quite frequently in service purchasing. Service contract renewal options facilitate annual price adjustments based on either economic price adjustment escalators/deescalators or pre-priced additions to the work. Many organizations award service contracts for a base year, with several one year options.

Payments. Service contracts generally involve invoicing and payment either on a monthly basis or based upon the "phases" of contract performance, which must be spelled out precisely in the contract.

Amount of Contract Administration. Administration of service contracts is highly resource intensive for several reasons, including additional labor law requirements, use of indefinite quantity contract types, option pricing, and the detailed quality assurance/control requirements needed. In the Public Sector, service contracts may be written to include cost reimbursement/reimbursable provisions. Cost reimbursement contracts require significantly more administration than fixed-price contracts. Even fixed-price service contracts, however, demand extensive inspection and contract management surveillance.

Establishing A Viable Service Outsourcing Program. In their Purchasing Today (September 1996) article entitled "Making the Transition," Mark Miller and Steve Fogle establish some effective guidelines for establishing and implementing a viable outsourcing program. I consider these guidelines applicable in both the public and private sectors. Miller and Fogle believe the strategic outsourcing team should (1) Consider the (ultimate) customer when outsourcing to assure an uninterrupted flow of products and services; (2) Include all costs in the make-versus-buy analysis (in the Federal Sector, the A-76 Cost Comparison handbooks assures this is accomplished); (3) Select a preferred supplier or be prepared to follow a thorough request for proposal procedure (public sector purchasers, of course, must follow the second option, since their procurement laws and regulations will typically require "full and open" competition to obtain "outsourced" services); (4) Select a supplier with initiative; (5) Make the supplier selection early; (6) Bring the supplier on a visit to your facility; (7) Send resources to the supplier's facility; and (8) Build an adequate bridge inventory before the move.

To these guidelines, I would add the following based upon my years of experience as a "Commercial-Industrial Activities Contracting Officer" with the Federal Government: (1) Establish a strategic planning organization, headed by a Vice President or other top manager, and assign to this organization a multi-functional strategic sourcing evaluation team consisting of professionals from the Engineering Department, Operations/Production Department, Purchasing Department, Marketing Department, and Finance/Accounting Department; (2) Establish an inventory of activities/functions which should be periodically "studied" to determine whether the services should continue to be performed in-house or by contract; (3) Coordinate and promulgate clear, precise, cost comparison and other methods of comparing in-house and contract performance and assign functional responsibilities for the conduct of these comparisons; and (4) Involve the Internal Audit/Review organization in the on-going and periodic review of all make-or-buy decisions to assure the process is fair and above-board.

How to become effective members of the organization's "Strategic Outsourcing Team." Purchasing members of the outsourcing team must learn to "think strategically and globally." Such thinking assumes a breadth and depth of vision which enables them to rise above the day-to-day "minutiae." Quite typically, an advanced degree or advanced coursework in business and management provides this type of perspective. In order to gain the global sourcing perspective, a comprehensive course on International Purchasing would be helpful.

Purchasing members of the outsourcing team must hone their service contracting, cost analysis, and negotiation skills. These skills can be obtained through a combination of coursework and OJT. There are any number of good consulting firms which can provide assistance in these areas, as well as the mechanics of establishing and maintaining a viable outsourcing program. The Outsourcing Institute in New York at 1-800-421-6767 can be a valuable resource in this regard.

Summary. The modern purchaser must master service purchasing/contracting in order to become an effective member of the organization's "strategic outsourcing team." Purchasers can increase their effectiveness by honing their skills not only in service contracts, but also in international contracting, cost analysis, and negotiation. As effective members of this team, purchasers can significantly contribute the to profitability and long-term viability of their organizations.

REFERENCES

Graw, LeRoy H., EdD, C.P.M., CPCM. Cost/Price Analysis: Tools to Improve Profit Margins. New York: Van Nostrand-Reinhold, 1994.

Graw, LeRoy H., EdD, C.P.M., CPCM and Deidre Maples, C.P.M. Service Purchasing: What Every Buyer Should Know. New York: Van Nostrand-Reinhold, 1994.

Karoway, Cherish. "Outsourcing Helps the Public Sector Pare Down." Purchasing Today®, September 1996, 29-30.

Miller, Mark S., C.P.M., CIRM, and Steve Fogle, C.P.M. "Making the Transition." Purchasing Today®, September, 1996, 33-34.


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