Balancing Power in Outsource Contract Agreements

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

Gavin Campbell
GA Advisory
gcampbell@ga-advisory.com
www.ga-advisory.com
+32 475 951 821

Gavin is a director at GA Advisory, a small and specialized consulting firm working with the Airlines, Express and Logistics industries. He has worked extensively in the area of performance improvement and organizational effectiveness in the manufatcurting, express and logistics industry, including 5 years as head of performance analysis at FedEx. Gavin has advised many of the worlds leading logistics and express companies, and has recently conducted assignments for DHL.

Gavin holds a law degree and an MBA from Henley Management College in England and is based out of Brussels Belgium.

Best Workplaces

The Best Workplaces report (Financial Times, April 28, 2005) notes... Read More

The Death Spiral

Sometimes things just happen. Maybe we lose focus and take... Read More

Turning a Negative Employee Into a Positive Asset

Several years ago, I took over the supervision of a... Read More

Dont Get Side-Tracked By The Nay-Sayers

You, the Entrepreneur, are 'normally' a type-A individual. One who... Read More

Building the Trust in Your Employees - 12 Easy Tips

In Stephen Covey's great book, "The Seven Habits of Highly... Read More

Character: Is It Necessary In Leadership? (Part One)

We know character when we see it, but what exactly... Read More

Lateral Thinking, Logical Thinking, Applied Creativity

Certain processes enhance creative output and others enhance innovative output.... Read More

Hiring Your First Business Personal Assistant: Some Guidelines for Successful Hiring

Hiring the first personal business assistant is an exciting time... Read More

Offshore This! (Outsourcing Tech Support Overseas)

So I call my telephone company and someone picks up... Read More

Service Level Agreement (SLA) Boot Camp

Service Level Agreements, or "SLA's" are tricky but useful mechanisms... Read More

Does Your State Like To Keep Your Workers Compensation Secrets Hidden?

Workers compensation secrets are hidden deep within piles and piles... Read More

When Business Becomes A Battlefield

"We have to be careful it's like a minefield out... Read More

Corporate Governance for Business Owners

It is clear that good Corporate Governance is in the... Read More

Compensation and Six Sigma Black Belts

One of the more ambiguous elements of a Six Sigma... Read More

3 Tests To Hire The Best

Question: What's the easiest, cheapest and quickest way to have... Read More

Uncommon Common Sense ? Know What is the Most Important Thing in Your Business

Over 3 of my meetings with 3 business owners last... Read More

Tales From the Corporate Frontlines: Managerial Influence

This article relates to the Manager/Supervisor competency, commonly evaluated in... Read More

Creating A Vision ? Bringing Your Dreams Into Reality

Do you have some goals you want to achieve or... Read More

Innovation Management ? does the idea fit with the firm?

Creativity can be defined as problem identification and idea generation... Read More

Management Consultants, Creativity, Innovation

Most firms have intelligent, capable, knowledgeable managers who are very... Read More

Improving Your Inter-Company Communications At No Cost

It's all very well having a flashy (and expensive) advertising... Read More

The High, High Price of Distrust

A paper manufacturer with over 300 employees once announced that... Read More

Take The Guesswork Out Of Problem Solving

In today's chaotic world and uncertain economic times too many... Read More

Building Trust in Your Business Relationships - 10 Steps

There are some simple things you can do with your... Read More

Identifying Candidates for Leadership

A critical task in the succession planning process of any... Read More