What sort of outsourcing contract do you really have?

Many organizations believe they have a strategic partnership with their outsourcing suppliers. In reality, most companies actually have a transactional business model and contract that they call a strategic partnership. How do you ensure your contract is fit for the value-driving ambitions of the future?

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The vast majority of buyer-supplier outsourcing deals in the market is based on a transactional business model, i.e., with a transaction-based contract. And over the last few decades, organizations have grown used to this commodity-based approach, driving down costs and pushing risks over to suppliers, who fight for deals with even the smallest increase in margin. Arguably, this has served everyone reasonably well: organizations save money, suppliers win contracts and the job gets done. 

But things are changing. Organizations today are looking for more than savings. They want transformation, innovation and continuous improvement, all infused with measurable performance analysis. At the same time, outsourcing providers have evolved from performing only siloed functional processes, increasing their capabilities to deliver higher-value services. 

Yet, the deals largely remain the same, and now the old model is starting to show cracks. 

For example, we encountered one contract in which a gulf had opened up between the client’s increasing expectations and the outsourcing provider’s ability to deliver, as demands went beyond the terms of the contract. The relationship had grown sour and the client was ready to sever it. However, the client didn’t realize they could, in fact, discuss the deal and renegotiate it — the answer was not to end the relationship, but to get closer to the provider.

In our experience, many executives don’t realize they have a choice in the type of deal they can broker. So, what are the options?

There are three basic types of economic models:

  • Transaction-based: the standard, commodity-based approach based on charges per unit or per hour, keeping the supplier at arm’s length
  • Output-based: a more operational agreement, based on agreed activities to be performed 
  • Outcome-based: a more evolved model based on mutual, strategic outcomes that span boundaries

 

There are also three types of outsourcing deals:

  • Transactional contract: a basic contract for buying a clearly defined off-the-shelf product or service
  • Relational contract: more dialog between buyer and supplier, with a greater focus on measurement and service level agreements (SLAs)
  • Investment contract: vertical integration between buyer and supplier, and longer-term investment, such as equity partnerships or shared services

 
How do you define what you have?
Put simply, you most likely have a transaction-based model with a transactional contract: this represents as many as 95% of the outsourcing deals in the current market. The issue facing these deals today, however, is that organizations are expecting more output- and outcome-based performance within the rigid transactional contract they’ve always had. 

It’s often the case that deals start out well, but after six months, both parties are beginning to argue over the specifics of outputs or performance. This can lead to the organization wanting to measure the smallest of details in an attempt to keep control of the supplier, which constricts performance even further.

As more organizations experience the sour taste of this breakdown, there is a growing appetite for the Vested methodology developed by a research group led by Kate Vitasek at the University of Tennessee. Vested is driving a transformation in how deals are approached, recognizing that there are typical problems that develop in a buyer-supplier relationship.
 
By contrast, relational or investment deals are based much more on relationships with increased transparency, greater collaboration and a common set of goals. If these are not familiar traits in your buyer-supplier relationship, the deal is almost certainly transactional.

So, with this in mind, a better approach would be to start with the question, “What kind of result do we want?”

Re-engineering buyer-supplier relationships
There are some basic rules to follow when redefining an outsourcing relationship, as set out in the Vested methodology:

  1. Focus on outcomes, not transactions
  2. Focus on the “what,” not the “how”
  3. Agree on clearly defined and measurable outcomes 
  4. Improve pricing-model incentives for cost and service trade-offs
  5. Enable the governance structure to provide insight, not just oversight

The journey toward adhering to these rules will almost certainly entail adopting output-based models. So, the first step is to get outside the box and think, “What might be the long-term goals of both organizations?” This will help everyone focus on a joint vision, from which several desired outcomes can be defined collaboratively.

For example, it might be that the supplier has long held a 10% margin as purely aspirational rather than a target that could actually be achievable. Yet, building that into a deal, in return for defined outcomes, could make it happen. It’s very likely that suppliers are fearful of changing their business model too, so agreeing on common goals can help instill in them the confidence that they can deliver. 

The future of deals
The output- and outcome-based models, and relational or investment contracts will not become dominant overnight. This is not the end of traditional transactional outsourcing deals. But, they will evolve.

The aim of the Vested approach is to create a win-win situation for both buyer and supplier. And, it can be applied to deals and organizations of all sizes and across sectors. For example, in the case of public sector deals, there can be much more transparency in discussions at the bid stage, depending on local legislation. Because costs are openly agreed, the focus moves away from them toward the cultural fit of buyer and supplier, which will inevitably lead to more harmonious and productive long-term relationships.  

This type of approach will see a reduction in disagreements and disputes. Parties will increasingly recognize that it’s neither the supplier’s nor the buyer’s fault if outcomes aren’t achieved — it’s actually the basis of the deal. 

In a partnership, there is more at stake: a unity of purpose, shared goals and benefits for both parties. And that’s worth investing in.

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