Canada: Value Drivers For IT Outsourcing Deals In An Economic Downturn — Part I

Outsourcing — the practice of handing over responsibility for the execution of many IT functions to an outside supplier like IBM — can be a shrewd business strategy in any economic climate. What we are learning as a result of the last number of months of hard economic times, is that outsourcing deals can become even more compelling in a recession. Why? Two words — "reduced costs."

What is happening in the outsourcing marketplace is that astute customers who have contracts with one or two years left on them are not waiting until these contracts run to the natural end of their terms. Rather, they are doing early renewals now, and adding three to five years onto the duration of the new contract, thereby concluding a new five- to seven year deal.

It's All About Reduced Costs

Why would a customer go through the cost and hassle of an early renewal of a major outsourcing agreement? These are significant contractual arrangements. A renewal will involve all sorts of updating of the paperwork, and copious homework to bolster that effort. So, why go through all this when you don't really have to? Two words — "reduced costs."

The deal is actually fairly straightforward. In return for the customer agreeing to tack extra years onto the current agreement, the supplier delivers new, lower prices immediately. Therefore, the customer doesn't have to wait two years to get a material reduction in its IT costs; rather, it can get them now. And now — in the middle of these harsh economic times — is when the customer really needs these additional cost savings.

A Win-Win Proposition

So what's in it for the supplier? Why would the supplier want to open up what is likely a fairly lucrative contract, and offer price reductions immediately? The last couple of years of an outsourcing agreement tend to be the most profitable for a supplier, so why give these up in favour of providing the customer with immediate price cuts? Three words — "avoid an RFP."

Consider the likely scenario where there is no early contract renewal of the existing deal. About 18 months before the contract ends, the customer will go to market with a Request for Proposal (RFP). The RFP will go to multiple suppliers. That means a competitive dynamic will be engaged, with the incumbent supplier having to bid against potentially much hungrier competitors. The incumbent supplier may lose the account to one of these competitors. But even if it keeps the work, it will be at reduced fees. And it has to bear the significant cost incurred in participating in a full-bodied RFP process.

Therefore, an early renewal of an existing deal has some real attractions for the supplier. Sure they will have to lower prices — but this was inevitable in any event. But on the positive side of the ledger, the supplier gets to keep the customer, and the term of the deal is extended another three to five years. Particularly in an economic downturn, this is a good result for the supplier — especially if, in the alternative scenario, the supplier loses the work altogether.

The Implications of Reduced Costs

How does the supplier effect the immediate cost savings? This is a very important question, one that all customers need to ask their suppliers ― not least because the answer will likely impact the risk profile of the deal for the customer, which in turn means that appropriate adjustments need to be made to the outsourcing agreement to manage these risks.

For example, one way a supplier will invariably reduce costs is by having some of the work done by its resources located in lower cost offshore centres, such as India, the Philippines, South America or Eastern Europe. This presents a riskier service profile for the customer, particularly if the supplier needs to handle personal information of customer's employees or clients in these foreign jurisdictions. Accordingly, amendments typically have to be made to the outsourcing agreement to 'beef up' confidentiality, privacy and security provisions. Also, the agreement's limit-of-liability clause needs to be revisited to ensure that the supplier is bearing a fair share of these additional risks.

Another cost reduction strategy involves moving the customer from a 'dedicated' service delivery model (e.g., where an entire mainframe computer is used only to process that single customer's data) to a 'utility' or shared-service delivery model (e.g., where the supplier's mainframe would support two or three customers simultaneously). Again, such a shift in the delivery solution will warrant some changes to the outsourcing agreement, in order to mitigate the greater risk presented by the new operations structure.

Watch the Pricing Fine Print

Where the supplier proposes to reduce costs by delivering a certain portion of the services from offshore centres — such as from India — you have to be very careful with the details proposed by the supplier around the new, lower pricing. Yes, the new unit pricing is reduced from the previous price, but — and this is a big but — the supplier likely will want to provide that the new price is now subject to foreign-exchange risk and foreign inflation adjustment. For example, if the Indian rupee appreciates against the Canadian dollar, the supplier wants you to bear this extra cost. Likewise, if Indian inflation exceeds a certain amount, the supplier wants you to pay the increased amount.

These two pricing issues — foreign exchange risk and foreign inflation — have become very contentious points in outsourcing deals that include a material offshore component. These two items can add significantly to the overall cost of a renewal deal (calculated over its entire length).

There are numerous ways to address these points. One is to shift the risk entirely to the supplier, but typically this is only done in return for a fixed-premium amount that is added to the regular monthly fees (in effect, this premium acts somewhat like insurance). Or, some customers are willing to agree to graduated risk-sharing formulas — such as the first three per cent of foreign inflation being the responsibility of the supplier, the next five per cent of inflation being shared 25-75 per cent, and anything above eight per cent being shared 50-50 per cent. How you approach this issue often is determined by how international your business is, and how comfortable you are manoeuvring in the world of foreign exchange and foreign inflation.

Responding with Greater Flexibility

One argument for having the supplier bear the entire risk for offshore inflation and currency risk is that the supplier is in the business of operating in many countries, and can therefore hedge this risk by shifting production to new, lower cost venues as warranted over the life of the new agreement. Indeed, the supplier is probably going to do something like this in any event, in order to keep your fees declining — and the supplier's margins healthy. So, there is a strong argument that the supplier has already baked into its price any foreign exchange and inflation risk.

In a similar vein, however, you must be willing to be fairly flexible in allowing the supplier to provide you service from different countries. Certainly you will want some pre-approval rights on the facilities from which the supplier provides the services, but you can expect this discretion on your part to be somewhat fettered so that it only speaks to issues such as site specific security, rather than to whether certain services can be provided from a specific country to begin with. In short, the more inflation/foreign currency risk you want the supplier to take on, the more flexibility you will need to show about site locations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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