- THE MAGAZINE
Whether a company is looking to outsource a non-core function across the street or across an ocean, the sourcing part of the equation will make or break the deal.
Here’s the rub: too many companies think of outsourcing as a make-versus-buy decision and not a continuum. To understand why requires a trip back in time to examine the evolution of outsourcing.
While outsourcing has been around for centuries, the 1990’s brought a new spotlight to outsourcing. Business gurus such as Tom Peters and Peter Drucker advised, “Do what you do best and outsource the rest!”
Outsourcing became socially acceptable (and desired) when the Harvard Business Review featured the leading thinking of Waterman and Peters on outsourcing non-core competencies. Many companies jumped on the outsourcing bandwagon by outsourcing complex services normally referred to as “back office” functions such as information technology, finance and accounting, facilities management, logistics and transportation, call center support, and human resources support.
Companies engaging in large-scale outsourcing efforts typically used the same buy-sell transaction-based sourcing models for buying complex services that they did for buying direct and indirect materials.
While businesses were changing what they sourced to include more complex services, no one really sat back and challenged how they outsourced. Today, virtually all businesses use the same transaction-based approach for procuring complex services such as outsourcing as they do to buy more simple commodities and supplies. The typical focus is on detailed transaction-level pricing – paying either for a business task (cost per warehouse pallet stored, cost per minute of call, or cost per IT server) or on a per-headcount basis.
After 20 years of outsourcing, many business professionals and academics are starting to challenge the transaction-based business model as the only sourcing business model.
Nobel Laureate Oliver E. Williamson was one of the first academics to challenge the traditional make-buy decision process with his work on Transaction Costs Economics. One of his key ideas was that companies should view outsourcing as a continuum rather than a simple market-based make-versus-buy decision.
Williamson’s deep economic research highlighted what is, on the surface, common sense – there are many hidden transaction costs that need to be considered when you decide to either “make” or “buy.”
If you choose to perform non-core work there is no competition, thus providing little incentive to drive improvements in cost and quality. There is also high administrative control and a legal system that is deferential to management. As a consequence, innovations that could come from the market or third parties are not developed as rapidly as management typically likes.
Using “the market” assumes that free market forces will work smoothly and fairly to incentivize suppliers to compete on low cost and high service. Williamson argues that this logic is flawed when outsourcing more complex services. If only commodities are outsourced, it is easy and inexpensive to switch suppliers. However, in more complex supplier relationships Williamson argues that suppliers are often “competed” into outsourcing agreements that pose unnecessary risks and have unreasonably low pricing models.
On the surface, it is great for buyers – low prices. However there’s a Catch-22. Companies that are using transactional, approved or even preferred supplier arrangements may find that their supplier/service providers are meeting contractual obligations and service levels, but they are not driving innovations and efficiencies at the pace or level the user would like to see.
Williamson argues that a “hybrid” approach is needed; one that uses collaboration and incentives to, in effect, purchase mutually targeted outcomes, rather than simply ticking boxes off and paying for transactions.
Today, the predominant sourcing business models are transaction-based business models. There are three types of transaction-based sourcing relationships that have evolved over time as businesses wrestle with ways to create service provider relationships that are better suited for more complex business requirements. These are: simple transaction providers, approved providers, and preferred providers.
The economics for each of these types of supplier relationships are very similar in that the supplier gets paid when it completes a transaction.
There is typically a pre-defined rate for each transaction, or unit of service. For example, a third party logistics service provider would get paid monthly for the number of pallets stored, the number of units picked, and the number of orders shipped.
Transaction-based business models are best when a supplier offers a standardized service which is easily measured through a commonly understood set of metrics. Payment can be triggered based on successful transactions completed.
A “Simple Transaction Provider” is a supplier who is one of many available in the marketplace, typically providing a low cost, repetitive service. The services provided are usually competitively bid, often with no interruption of service or impact on the business.
Simple transactions are often triggered by a purchase order which signals that the buying company agrees to buy a set quantity of goods, tasks or hours.
An “Approved Provider” is a supplier identified as offering a unique differentiation from other transactional suppliers and provides a cost or efficiency advantage for the client company. The differentiation could be in the form of geographical location advantage, a cost or quality advantage or an external advantage such as meeting the client company MWBE (Minority and Women-owned Business Enterprise) goals. An Approved Provider is identified as a pre-qualified option in the pool of transactional suppliers and has fulfilled preconditions for specified service.
A “Preferred Provider” is a supplier that has been qualified, may have a unique differentiator, and has had demonstrated performance with the buying company. Typical conditions are met such as:
• Previous experience
• Supplier performance rating
• Previous contract compliance performance
• Evidence of an external certification (e.g. such as ISO certification)
Companies will often seek to do business with a Preferred Provider in an effort to streamline their buying process and build relationships with key suppliers. They then enter into a longer-term contract using a Master Services Agreement that allows for the companies to do repeat business efficiently. It is common for Preferred Providers to work under a blanket purchase order with pre-defined rates for work. A Preferred Provider is still engaged in a transactional business model, but the nature and efficiencies in how the companies work together goes beyond a simple purchase order.
An outcome-based business model pays a service provider for accomplishing a defined set of business outcomes, business results, or achievement of agreed-upon key performance indicators. Outcome-based approaches are used most widely in the aerospace and defense industries. They are also referred to as performance-based logistics because they link maintenance and support to the procurement of the product.
Rolls-Royce PLC was the first known organization to explore outcome-based approaches in the 1960s with the development of its “Power by the Hour” jet engine maintenance program. However, outcome-based business models did not gain real traction until around 2000, and their use still is limited.
An outcome-based business model typically shifts risk for achieving the outcome to the service provider.
There are two types of outcome-based business models; a performance-based agreement and a Vested Outsourcing agreement.
The relationship with suppliers under a performance-based agreement is different than with transactional providers. Typically performance-based agreements begin to shift the thinking away from merely quantitative “bean-counting” activities to outcomes; but they often still pay a supplier using transaction-based pricing mechanisms. These contracts are often also called “pay for performance” because they frequently include an incentive or a penalty tied to a specific service level outlined in the contract. They usually require a higher level of interaction between a service provider and a buying company in order to review performance against objectives and determine the reward or penalty options that are typically embedded in the contract.
Vested outsourcing is a hybrid approach. University of Tennessee researchers studied a number successful hybrid outsourcing arrangements, and the concepts and principles derived from that research formulated a hybrid business model that we call “Vested Outsourcing.” It combines various sourcing models to yield a greater value proposition than previously known by using a combination of an investment-based business model with the inherent incentives and flexibility of a market-based approach.
Vested outsourcing leverages components of an outcome-based model with the Nobel Prize-winning concepts of behavioral economics and the principles of shared value. Behavioral economics is evolving more broadly into the concept of relational economics, which proposes that economic value can be expanded through positive relationship (win-win) thinking rather than adversarial relationships (I-win-you-lose).
Shared value principles are concepts of creating economic value in a way that creates value for all parties involved. Entities work together to bring innovations that benefit all parties—with a conscious effort that the parties gain or share in the rewards. This shared-value thinking is what the University of Tennessee researchers call “what’s in it for we” (WIIFWe).
When improvements and cooperation occur, the trust that exists between the parties enables them to unlock far more innovation and value than outdated power-based transactional approaches.
The vested business model takes outcome-based approaches a significant step further than performance-based agreements. It represents an operational and mindset change in how outsourcing is approached. A vested agreement is based on specific desired outcomes that are the basis of the enterprise. We define a desired outcome as a measurable business objective that focuses on what will be accomplished as a result of the work performed. It’s not a task-oriented service-level agreement (SLA) that often is mentioned in a conventional statement of work or performance-based agreements. Rather it is a mutually agreed upon, objective, and measurable deliverable for which the service provider will be rewarded—even if some of the accountability is shared with the company that is outsourcing. A desired outcome is generally categorized as an improvement to cost, schedule, market share, revenue, customer service levels, or performance.
The vested business model is best used when a company wants to move beyond having a service provider perform a set of directed tasks and wants to develop a solution based on mutual advantage to achieve the company’s desired outcomes. The vested hybrid model requires the parties to build a solid, cooperative foundation for sharing value.
Does it work?
There are success stories across multiple industries and types of outsourced services:
• Jaguar moved from the ninth spot in the J. D. Power customer satisfaction rankings to No. 1 in its partnership with Unipart for worldwide supply chain management services.
• Microsoft won three awards for its agreement with Accenture for back-office procure-to-pay.
• The U.S. Department of Energy won the Project Management prestigious “Project of the Year” Award for its work with Kaiser-Hill on the Rocky Flats nuclear site environmental clean-up project.
Companies struggling to meet complex business requirements using conventional transaction-based or outcome-based approaches may decide to invest to develop capabilities themselves—or insource. In such cases, many choose to adopt what is commonly referred to as a “shared services” structure, which is the establishment of an internal organization modeled on an arms-length outsourcing arrangement.
Using this approach, processes are typically centralized into a shared service organization and departments are cross-charged for the services used.
Some companies decide they do not have the internal capabilities, yet they do not want to outsource for a variety of reasons. In these cases, they may opt to develop a joint venture or other legal form in an effort to acquire mission-critical goods and services.
These equity partnerships can take different legal forms – from buying a service provider, to becoming a subsidiary, to equity-sharing joint ventures. These partnerships often require the strategic interweaving of infrastructure and heavy co-investment.
Equity partnerships, by default, bring costs “in house” and create a fixed cost burden. As a result, equity partnerships often conflict with the desires of many organizations to create more variable and flexible cost structures on their balance sheets.
The Vested model aligns the interests of the company with the interest of the service provider by following five rules or principles for structuring the buyer-supplier relationship. These rules—if followed by shared services organizations—will align the interests of internal shares services organizations with their internal customers.
The result is a collaborative outsourcing agreement in which the parties are truly vested in each other’s success and a partnership that is built for the long-term win-win. wt
The Five Rules of Vested Outsourcing
The five rules of vested – or collaborative – outsourcing will take the outsourcing relationship out of the transaction-based format.
Rule 1 – Focus on outcomes, not transactions
Rule 2 – Focus the parties on the “what,” not the “how”
Rule 3 – Incorporate clearly defined and measurable outcomes
Rule 4 – Use a pricing model that features incentives to optimize cost and service tradeoffs
Rule 5 – Establish an agreement governance framework based on insight rather than oversight.