Outsourcing: Avoiding the Hazards and Pitfalls

Author(s):

X. Paul Humbert, Esq.
X. Paul Humbert, Esq., Newark, New Jersey 07101 (201) 430-6481.
Ralph A. Passarelli, C.P.M.
Ralph A. Passarelli, C.P.M., Stamford, Connecticut 06927 (203) 357-6691.

82nd Annual International Conference Proceedings - 1997 

The views expressed herein are the personal opinions of the authors and are not necessarily those of any other persons or entities.

MEETING COMPETITION. Intense competition is forcing corporations to simultaneously cut costs and improve quality. In response, organizations are increasingly focused on their core competencies and relative competitive strengths. In order to meet their competitive challenges, many corporations are outsourcing non-core functions to highly specialized firms who can bring their expertise and efficiencies to bear on the outsourced functions. Although outsourcing has its drawbacks and should not be viewed as a panacea, under the right circumstances, and with due sensitivity to the associated risks and potential pitfalls, outsourcing can be a part of overall "smart sourcing" and make good business sense.

FAVORABLE PRESS REPORTS. It is a fact of life that corporations prefer to issue positive press releases. Sometimes "publicity" is part of the "bargain" made between the purchaser and the external provider. Moreover, most press reports are written during the initial phase of the outsourcing agreement when savings are "anticipated" or "projected." Although there are some negative stories regarding the risks and potential pitfalls of outsourcing (and predicting an eventual trend back to "insourcing"), most reported press has been positive.

BUSINESS PROCESS OUTSOURCING. Another reason for the outsourcing bandwagon is that large consulting firms are pursuing outsourcing as a major business opportunity as part of the "commodizitation" of generic services. Essentially, larger consulting firms are advising their clients to consider not only IT outsourcing, but "Business Process Outsourcing" or "BPO" which can include some or all (the "Keys to the Kingdom" approach) non-core competencies. In response to this initiative and to compete against the large external providers, smaller external providers are banding together (forming strategic alliances) in order to be able to deliver "one-stop shopping" in the form of a consortium made up of several entities.

COORDINATING AND MANAGING THE EFFORT. Outsourcing contracts are complex. One of the many challenges to overcome as consulting firms and IT providers move into the Business Process Outsourcing market will be for purchasers to manage and coordinate the effort, particularly where several external providers are expected to interact with each other while controlling multiple corporate functions. Corporations need to be prepared to spend money and talent to manage the effort. It is important to ensure that the persons charged with managing the outsourcing contract have the necessary skill sets. Managing a department with the emphasis on coordinating the efforts of employees, is far different from managing an outsourcing contract.

THE RELATIONSHIP: SUPPLIER OR PARTNER? At its highest level, outsourcing can take the form of an alliance akin to a partnership or joint venture. Particularly where non-core but essential functions are outsourced, the contractual relationship needs to be clearly defined and carefully managed. However, the considerations that go into choosing and contracting with a "partner", as opposed to a supplier, are complex.

The terms "partnering" or "strategic alliance" should not be used to describe an outsourcing agreement unless the contract is structured to reflect a true partnering relationship or strategic alliance, i.e. a close working relationship based on trust, communication, and mutual dependency where both parties have a vested interest in reducing costs and achieving a favorable business outcome. That means that the external provider's "reward" must be based on results or meeting objectives rather than simply being compensated to "try hard" or perform discreet tasks.

Not all outsourcing deals need to be "partnerships" or "strategic alliances". Sometimes, a straight "supplier" relationship is all the parties really need or want. Moreover, it can be very dangerous to refer to a relationship as a strategic alliance or partnership when, in fact, it is nothing more than a traditional contract. Typically, "partners" in a legal sense can act as each other's agent and owe one another "fiduciary" duties. That's not he type of relationship you want to have with everyone.

WHAT SHOULD BE OUTSOURCED? Deciding what to outsource starts with deciding what core competencies provide the organization's comparative advantages. However, defining and drawing a "bright line" as to what is or is not core may not always be easy. The tendency is to define what one does as core or critical and what everyone else does as non-core or less critical. Instead of trying to decide the ultimate question, it makes sense to identify "high potentials" for selective outsourcing (out-tasking specific services) and prioritize the effort in those areas where the internal sources are delivering "high cost, low quality" goods or services. Non-core functions that are transaction oriented, repetitive processes (e.g., food, maintenance, security or administrative services) which are relatively simple and easily segregated from other corporate activities have traditionally been identified as high potentials for outsourcing.

OUTSOURCING STEPS. Outsourcing should be a well-organized process that questions preconceived notions or assumptions and tests conclusions. Essentially, here's what needs to be done:

  1. Decide what functions are the essence of a corporation's comparative advantage;
  2. Develop a comprehensive business plan to achieve the corporation's objectives;
  3. Identify and evaluate non-core functions for potential outsourcing based on a careful cost benefit analysis;
  4. Understand both the corporation's and the external provider's cost structures and profit margins;
  5. Clearly and completely articulate the parties' respective responsibilities, anticipating changes in needs and technology.
  6. Develop a detailed contract with input from legal and business experts and avoid using the external provider's standard form of agreement;
  7. Make a careful and considered selection as to which external provider can best perform the work and meet the corporation's objectives;
  8. Develop a migration plan for transitioning the function(s) to the external provider(s);
  9. Exercise continuous and active cost control, monitoring, process improvement, and oversight; and
  10. Have a "transition back" plan in place that allows the corporation to "recapture" the function or permits it to "migrate" to a new external provider in the event disengagement becomes necessary.

POTENTIAL ADVANTAGES TO OUTSOURCING: REDUCED COSTS - The price of outsourced services should reflect economies of scale and increased efficiency, including dealing with demand variability. The sale of equipment or facilities previously used to perform the function can also be a source of funds. IMPROVED QUALITY - An external provider with specialized expertise and access to the latest advances in technology can sometimes deliver improved quality provided there is the incentive to stay focused on client needs and objectives. FEWER DISTRACTIONS - Outsourcing functions previously performed internally frees management from the burden of daily control and allows it to focus on strategic initiatives. RESOURCE ALLOCATION - Goods or services can be obtained on a "pay-as-you-go" basis without the need to make long-term capital investments. It can also provide resources on an "as needed" basis regardless of "peaks and valleys" in demand.

POTENTIAL DISADVANTAGES TO OUTSOURCING. LOSS OF CONTROL - If management abdicates the entire process to the external provider and fails to continuously and actively manage the contract and relationship, loss of control and key skills can result in overdependency (the "hostage-on-a-pirate-ship" scenario). If the extreme provider does not make the right investments, technological obsolescence is a big risk. Ironically, outsourcing could also restrict the ability to engage in further restructuring if the contract cannot be changed. LOSS OF CLIENT FOCUS - The external provider's goals and objectives may differ from those of the client, and over time may lose touch with the corporation's business plan and strategy, particularly where change is frequent or significant. LACK OF CLARITY - The failure to clearly articulate and agree upon the parties' respective responsibilities is a major concern which can lead to costly and disruptive disputes and claims of "extra" or so-called "out of scope" work. LACK OF COST CONTROL - Changes in company objectives and escalating pricing can drive costs beyond expectations, particularly if the contract does not include long-term pricing with built-in incentives to stay competitive, control costs and improve quality.

UNDERSTANDING THE MARGIN. Outsourcing inevitably leads to some loss of control. The risk is that losing the ability to perform the work internally will lead to overdependency. In addition, barriers to entry, such as the time and expense necessary to train a workforce to become knowledgeable about the corporation's specialized needs and requirements may hamper the ability to shift to another external provider. As time passes and dependency grows, the original "savings" may disappear.

ACCESS TO COSTS. Unless the corporation has access to and understands the external provider's costs and ongoing cost reduction and control mechanisms are part of the contract, external providers will be tempted to raise prices in order to increase their margins. Throughout the outsourcing relationship, costs will have to be discussed, negotiated and controlled as part of a continuous joint effort by both parties. Simply outsourcing a function may not actually reduce costs long-term unless it is recognized that every activity has costs regardless of who's performing them. The need for, and cost of, activities needs to be continually evaluated and maintained, reduced, or eliminated as appropriate.

ARTICULATING RESPONSIBILITIES. Regardless of whether the parties are considering forming a so-called "strategic alliance" or entering into a traditional "buyer-supplier" relationship, clearly and completely articulating the parties' respective responsibilities is by far the most important part of any outsourcing arrangement. AVOID "HANDSHAKE" DEALS. Do not assume that simply because the parties are contemplating some form of "partnering" or otherwise becoming "strategically allied" (with all its potential variations and differing connotations) that a detailed and specific written agreement is not necessary.

DURATION AND RENEWALS. External providers will usually prefer relatively long-term (five to ten years) agreements whereas purchasers will typically want a shorter term (three to five years). The trend seems to be toward shorter-term agreements in order to provide the external provider with a continued incentive to perform and facilitate "exit" strategies.

Unlike other types of transactions, an outsourcing contract can never be allowed to simply expire. The whole point of an outsourcing arrangement is continuity of service. Moreover, it may take a year or more to select and transition to an alternative external provider.

Ideally, the purchaser should have the right or "option" to renew at a predetermined price that was agreed to when the contract was initially entered into. Avoid the "automatic renewal" trap where the burden is on the purchaser to take affirmative steps (typically within a short time frame) to avoid being "locked" into a renewal. Remember that even if you have the option to renew at favorable pricing, you may want to begin "negotiations" a year or more before the agreement ends. Whatever the arrangement, keeping track of when the agreement will expire is crucial.

PRICING OVER THE LONG TERM. Outsourcing contracts tend to be relatively long-term. It is notoriously difficult to price services over the long term. Progressive (automatic price increases every year) or escalating (price increases tied to an index) pricing each have serious drawbacks.

Increasing prices every year may not reflect the supplier's actual change (either increases or decreases) in cost. Ideally, process improvements and better technologies should drive cost (and pricing) down over time. Escalation clauses tied to an index, such as one of the two "Consumer Price Indexes" prepared by the Bureau of Labor Statistics, may bear absolutely no relationship to the supplier's actual costs. This is because indexes tend to be broad-based and made up of components that do not affect the supplier's costs. Keeping the term of the agreement relatively short with the option to renew for subsequent terms if favorable pricing can be agreed upon is a better approach.

LIQUIDATED DAMAGES. When at the time a contract is entered into, damages due to a breach would be very difficult to determine, the parties can agree that a certain dollar amount will be payable as liquidated damages for the breach. However, this amount must be a reasonable forecast of the damages caused by the breach and be compensatory rather than punitive in nature. Since liquidated damages operate as a "cap" or limit on liability, it is important that the amount is not set so low as to be an attractive "option" not to perform. By the same token, liquidated damages cannot be set so high as to amount to an unenforceable penalty or punishment for breach. Remember that although liquidated damages eliminate the need to prove the dollar amount of the damages, the fact of the breach must still be established.

Liquidated damages are especially well suited to situations like outsourcing agreements where there are (or should be) clearly defined deliverables such as specified service levels, work volumes, milestones, due dates, or response and turnaround times. Be sure to specify whether the liquidated damages apply to all or just certain breaches. For example, you can set liquidated damages for delay but still recover actual damages for other types of breaches or damages where the dollar amount of damages are easier to prove. In an outsourcing context, you are really seeking to keep the external provider motivated and focused. Note that you can have liquidated damages, but not incentives payments, or you can have both. There is no requirement that you have incentive payments (which are compensation for doing well) just because the parties have stipulated damages in the event of a breach.

LEASES AND LICENSES. Some leases and licenses restrict use or access to the signatories and forbid any use by or "assignment" to third parties. Even if a corporation has no current plans to outsource, the possibility of outsourcing a particular function in the future needs to be considered. For example, equipment or office leases and software licenses should be negotiated to reflect that the items, space or software can be used by an external provider at no additional charge or expense. Where the external provider will be using software to deliver the outsourced services, software licensing issues loom large. Properly managing software rights are a critical part of any outsourcing effort. Accordingly: 1) Avoid violating existing licensing agreements, and 2) Avoid overdependence by preserving the corporation's ability to transition back" in-house or "migrate" to another supplier. This is especially important where the corporation will be using software provided by the external provider. The corporation needs to secure the right to continue using that software in the event of termination.

THE ASSIGNMENT "TRAP". ANTICIPATE CHANGES IN CORPORATE STRUCTURE - Corporations are changing and evolving in an effort to become more competitive. Accordingly, management needs to anticipate the possibility that a particular function may one day be sold or "spun-off" to an affiliate, subsidiary, or other legal entity. Thus, leases and licenses being negotiated today need to reflect that contingency. RETAIN THE RIGHT TO REJECT ASSIGNMENT TO A THIRD PARTY - Note that although it might make sense for the recipient of services to have the right to transfer or assign its rights under the agreement to another entity, the same is not true for the external provider. Having made a careful selection and picked the supplier based on its special expertise, corporations should not be required to accept services from another entity. By analogy, if you hired "Michelangelo" to paint your portrait, you do want him to assign that obligation to "Harry the Painter".

KEY PERSONNEL. THE PROVIDER'S EMPLOYEES - Making a careful selection includes ensuring that claims match its actual capabilities. Although an organization may look good on paper and have an excellent reputation, individuals can and often do make the difference. Key personnel to be supplied by the external provider should be carefully screened and selected. Once assigned to the project, these personnel develop insights that may be hard to duplicate or take time to transfer to another person. Placing reasonable restrictions on an external provider's ability to assign and reassign key personnel to other projects can protect continuity and the working relationship that has developed. There should be an understanding and disincentive against having key staff personnel pulled off to go work on "hot" projects elsewhere. THE PURCHASER'S EMPLOYEES - "Key personnel" also includes certain Company employees. For example, the Company employees who were intimately involved in the selection of the outsourcing provider and the negotiation of the contract will need to continue to play a key role in the administration and interpretation of the contract. It is possible that, over time, uncertainty (or even disagreements) will develop about what the parties intended in terms of scope of work, respective responsibilities, performance levels, and the like. It is often difficult to perfectly reflect all nuances in a written document. Thus, the Company's negotiators and other key personnel should continue to be involved on the Company's behalf in interpreting administration and the outsourcing contract.

CAPTURING ALL VERBAL REPRESENTATIONS. Like all contracts, outsourcing agreements contain "entire agreement" or "integration" clauses designed to exclude any written or verbal representations (what lawyers call "parole evidence") that purport to vary or contradict the terms of the written agreement. Such clauses typically recite words to the effect that "This Agreement is our entire and only agreement, and no other document or statements are part of the Agreement." Despite such clauses, many purchasers rely on verbal representations in making their decisions. Avoid problems: include or incorporate all important statements into the final written agreement. If the proposal is going to be incorporated into the contract, remember to have the external provider amend or update its proposal to reflect any improvements made during the course of negotiations and verify that this has, in fact, been done.

DATA OWNERSHIP AND RETURN. The outsourcing agreement should specify that the external provider shall return the corporation's proprietary or confidential data and information upon either expiration or termination, whether for cause or convenience. The Agreement should also specify the form and the means by which the data should be returned. After the data has been returned, the external provider should be required to delete any remaining data belonging to the corporation from the external provider's files. The return of such data or information should not be contingent upon whether the corporation has complied with its obligations under the agreement, since this can be a subjective determination.

BUYBACK AND BUYOUT OPTIONS. The "transition back" plan should anticipate the possibility that the corporation may one day wish to recapture or "buyback" any assets sold to the external provider, as well as a "buyout" of the external provider's investment in the effort. The price or valuation method for exercising such "buyback" or "buyout" options should be negotiated up front as part of the outsourcing agreement.

CONTINUOUS NEGOTIATION. Whatever the duration of the Agreement, the negotiation process will not end with the signing of the Agreement. Managing the outsourcing relationship involves continuous and ongoing negotiation due to differences as to what is within scope and changes in needs or requirements. Once the deal is signed and a corporation's facilities, systems, or personnel are turned over to an external provider, these negotiations will shift from a competitive environment to what is, in effect, a single-source procurement. Hence the need to structure long-term outsourcing agreements on measurable performance based pricing so that disputes are minimized and changes managed. Corporations can maintain at least some leverage throughout the relationship by keeping the term relatively short, outsourcing selectively, and having a well-planned exit strategy (transition back plan).

OUTSOURCING GUIDELINES. The following guidelines may be helpful in structuring outsourcing transactions:

  1. SPECIFY PERFORMANCE LEVELS AND TARGETS - If appropriate, use current performance as a baseline from which to measure improvement.
  2. SPECIFY HOW PERFORMANCE WILL BE MEASURED - Define the measurement criteria, as well as the form and frequency of reporting requirements. Consider using "customer satisfaction" based on survey results as one means of measuring performance.
  3. INTEGRATE THE COMPANY'S BUSINESS PLAN AND OBJECTIVES - Make sure the agreement reflects your business plan and objectives and is flexible enough to accommodate change.
  4. TIE PAYMENT TO PERFORMANCE - Structure payment provisions to reward performance, share savings, and provide incentives, but set liquidated damages for non-performance.
  5. ANTICIPATE INCREASES AND DECREASES IN SCOPE OR COSTS - Particularly in long-term contracts, structure pricing to reflect changes in scope and cost.
  6. ALLOW THE OUTSOURCER TO MAKE A REASONABLE PROFIT - Expect the outsourcer to make a profit, but require candid discussion and disclosure of costs, as well as "open-book" accounting.
  7. ACTIVELY MANAGE THE CONTRACT AND RELATIONSHIP - Don't abdicate responsibility. Have a continuous and active focus on performance levels, solving problems and making improvements, as well as shared objectives.
  8. TAKE THE TIME TO DO IT RIGHT - Balance the desire to quickly cut costs against the need to clearly define the respective responsibilities of the parties.
  9. THINK OF THE END AT THE BEGINNING - Anticipate and plan for the day that the relationship will end and that the services will be performed by someone else or "mitigate" back to the Company.

MANAGING THE CONTRACT. As with any commercial transaction, a contract which clearly defines the respective rights and responsibilities of the parties is critical to the success of the effort. It follows that if the parties have expended the time and effort to negotiate a detailed agreement with specific service levels and deliverables, the parties (and especially the purchaser) have a strong financial and operational interest in ensuring that the terms of the deal are followed. Since the contract contains the criteria by which performance is measured, it is imperative that the outsourcing agreement be followed and used as part of the ongoing operations and not simply filed and forgotten. Often the person who had been involved in managing the outsourced department or function is assigned to manage the outsourcing contract. However, managing a department or function does not necessarily include the skill sets required to manage the contract and the attendant relationship with the external provider.

DELEGATION VS. ACCOUNTABILITY. One important caveat cannot be over stressed. Outsourcing does not lessen a manager's ultimate accountability. Although one can delegate execution or performance to an external provider, the responsible manager is always accountable, regardless of whether the function is performed "in-house" or on an outsourced basis.

CONCLUSION. Outsourcing has both potential advantages and pitfalls which need to be carefully considered and managed. A clear and complete articulation of the parties' respective responsibilities in the form of a well-conceived agreement, as well as a proper contract administration and management, are key to ensuring a successful outsourcing effort.


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