Counting The Cost Of Outsourcing

Introduction

Aside from perhaps service, there is nothing more fundamental to outsourcing than cost and price.

In order to give a foundation to the pricing models that could ultimately be used in an outsourcing, it is vitally important to firstly place your deal in context.

I make no apologies for saying that it is this context which I will be discussing for the majority of this article. It is never a good idea to put the "cart before the horse" and attempt to impose a particular pricing structure on a deal without first taking a long critical hard look at those factors which will influence price and risk.

Deal Shapes

Inevitably the first consideration that needs to be brought to mind is the type of deal that you are pricing up. At the most basic level, a deal will have characteristics (I call them a "deal shape") which will lend themselves generally to a particular pricing methodology. So let's begin by looking at some typical deal shapes to get an understanding of how this works in practice.

It is important to bear in mind that these are not hard and fast rules – but guidelines.

• IT/Business Process Outsourcing

Classically structured IT and business process outsourcing deals are traditionally priced by way of a rolling monthly "standing charge", usually payable monthly in advance, which reflects all of the amortised costs that the supplier has to pay in order to manage the outsourcing, such as staff salaries, premises overhead (rentals/lease payments) and software and hardware maintenance and licensing costs. This standing charge (or service charge as it is sometimes referred to) is typically supplemented by a rolling top-up charge payable in arrears (to cover unforeseen items not accounted for in the standing charge) where it is agreed that these items should be paid for by the customer.

• Applications Management/ASP

Applications Management or ASP deals are essentially "feeding and watering" deals. The supplier basically provides the IT infrastructure remotely, and the customer pays for what they use. As you can see, this type of deal lends itself very well to utility or transaction based pricing, where the customer essentially pays on a "utility basis" for resource consumed.

• Consultancy and Projects

A consultancy or project based deal could be charged on either a fixed-price basis (ie a fixed immutable sum) or on a rolling time and materials basis (in other words a rolling per hour cost model similar to the one deployed by law firms and other professional advisors) depending upon the scope and duration of the assignment.

• Development/ERP Implementation

Likewise, a development deal could be based on fixed price or time and materials. These deals tend to be time critical, and sometimes this time criticality is reflected in the pricing mechanism, so for example it is commonplace in these circumstances to include liquidated damages: these are reverse payments from the supplier in the event that it delays any particular element of the project.

"Closed Scope"/ "Open Ended" deals

What are the other factors which can influence the pricing model used on a deal ? Well, scope has an important role to play. If a deal is well defined in terms of its scope, with defined commencement, transition, steady state and exit phases; together with a clear understanding on the part of the parties as to the length of the deal and the actual and potential "risks" that might be faced (closed scope), then it should (in principle) be relatively easy for the parties to price in a stable "standing charge" mechanism. The supplier will be reassured that it is not likely to be exposed to unplanned costs and should therefore also be more comfortable about not adding a premium to its pricing (of which more later); the customer will consequently get the reassurance that they are obtaining the best price possible for the deal without any hidden premiums being added.

Conversely, if the deal is perceived as being "open ended", with little constraint in terms of scope, it is going to be very difficult for the parties to reach this mutual level of comfort. The end result will be a higher price (because the supplier will need to hedge its risk exposure).

All of this illustrates that it is extremely important for the parties to define and understand the scope and parameters of the deal that they are seeking to price. Closed and defined scope essentially means lower risk which in turn defines a lower price.

Innovation (i.e. has it been done before ?)

The next factor, innovation, is also one that can drive pricing and cost on an outsourcing deal. The key issue is essentially one which is an extension of the scope discussion above.

If a deal is one which is carried out on a regular basis by the supplier (or is one which is essentially commonplace in the industry), then the parties can rely on economies of scale and established infrastructure and methodologies to keep the price down. In essence if the supplier has many customers receiving the same service from the same data centre, then the costs of providing that service will be leveraged down and therefore should be lower.

At the lower end of the outsourcing scale, this could even translate to the provision of a "utility" service, and might mean that utility or transaction based pricing is more appropriate.

Conversely, consider the effect on pricing if the deal is one which is innovative in the market – or at the very least, one which the supplier has no personal experience of carrying out. There are no such economies of scale and any infrastructure and methodology which will be used to support the service is likely to need to be built from scratch. Such a deal is likely therefore to put the supplier on an extremely cautious footing in relation to its pricing, and it is very usual in this case for the net effect to be an increase in costs. Equally, suppliers are likely to want to put the cost methodology onto an extremely conservative footing to enable them to recover as much as possible from the customer.

The lesson to be learned from a pricing perspective must therefore be to steer clear of innovation, unless it is an absolute necessity.

Due Diligence and Benchmarking (internal/external)

Of course, one of the best, tried and tested, ways to understand what you should be paying for your outsourcing deal, and to a lesser extent, how you should be paying,is to carry out a due diligence and benchmarking exercise. This can and should be done on both an internal and external basis – although frequently only one or the other exercise is carried out.

The part of the business which is due to be outsourced should be looked at from an operational perspective to see precisely what it costs to run on a fully in-sourced basis (ie before the outsourcing).

In an ideal world, this should then be coupled with a benchmarking exercise focussed on the external market to determine what the best value for money price should be for the provision of services to cover the outsourcing of that business function.

• Comparators

Some typical comparators that are typically used in a price benchmarking exercise include:

This comparator compares the suppliers costs with your own "insourced" costs (ie the price you pay for running the service). Generally, price "as is" comparators are liked by top management because it gives them a baseline grounding in what the in-sourced service costs the business and therefore a better view on whether suppliers are offering "value for money" in relation to that baseline.

hat it does not do however is enable a party to judge whether prices in the market offered by suppliers are cost effective: the baseline is entirely dependent upon internal costs which could be unrepresentative (ie the internal service could be mismanaged which could make it prohibitively expensive. In this context, any supplier will easily beat the "baseline"). It is also worth noting that suppliers tend to pay far less for the same IT services than non-IT suppliers pay.

This entails comparing the costs with the costs of other organisations for the provision of the services. In essence, what do other customers in the market pay for those services.

Obviously this is the classic "benchmarking" exercise as it is typically referred to in an outsourcing agreement. Although such an approach is beneficial for the customer because it enables to the customer to get a top down market view of prices typically paid by similar organisations for similar services (in a way that Price "as is" exercises cannot) the relevant data for such an exercise is not easily obtained.

It is usual in these circumstances for the customer to engage a benchmarking expert, such as Gartner, to evaluate what the "should be" price range should in fact be.

This comparator entails comparing the price being charged by your supplier with what other suppliers might charge you. Price/bid comparisons are popular because they give managers a "range" of outsourcing costs and they can also indicate trends in the market. This approach effectively compares list prices of different suppliers.

It is an obvious point, but a price/bid approach is usually quite easy to undertake as they are usually conducted via an RFP process which enables managers to see competing bids from different organisations.

Entry Costs

The other factors which cannot be ignored in relation to pricing up an outsourcing deal are the "entry costs". These are the costs which will need to be expended in order to get the service started and up and running.

I should explain at the outset that if you were to produce a chart of a typical cost model on an outsourcing deal, it would appear like a peak at the beginning and flatten out towards the end, with perhaps a mini peak on termination. This is because most of the cost on an outsourcing is expended at the outset to get it running. Suppliers bear these costs, but tend to amortise them over the term of the outsourcing agreement. This is why, when an outsourcing agreement is put out to tender that you find that supplier costs for running the same service for 5 years tend to be higher than those costs for running the service for 10 years: the amortisation cost curve is shorter and that results in higher payments.

In most cases, these costs will be borne by the supplier and recovered through the "standing charge" mechanism that I described above, so that ultimately they are paid for by the customer. In a minority of cases, the customer asks the supplier to bear the risk of some of these "entry costs" as a condition precedent for entering into the deal. Obviously, how these costs are attributed as between customer and supplier is a key function of the outsourcing pricing model, and, it goes without saying, can have a key influence on the price paid by the customer.

It is probably therefore worthwhile running through some of these costs so that you can get a greater appreciation of how these impact upon outsourcing pricing.

• Time of Essence set up/implementation (Liquidated Damages)

Probably the most legal of the heads of cost, but extremely relevant to the supplier's risk exposure. For the uninitiated, these are payments made by the supplier if there has been a delay in a particular aspect of a project. They are most commonly employed in a start-up situation, where the supplier is on a time critical path to implement a solution, develop a program or cut-over on an outsourced service. Typical liquidated damages provisions provide for a defined amount to be paid back to the customer for every day or week of delay.

"Time of the essence" approaches simply dictate that time is a fundamental condition of the agreement and give the customer the right to rescind the agreement in addition to claiming damages if the supplier is late.

Obviously, in the context of outsourcing cost modelling, the supplier is generally going to attempt to price the risk of liquidated damages and "time of the essence" into the deal costs. The price pressure in these circumstances will not be downwards.

• Premises

In an outsourcing deal, premises – that is to say, the buildings from which the service is to be provided, can be a substantial cost item.

Premises can be dealt with in a number of ways. In a classic "full service" outsourcing, the premises (usually a data centre and/or a call centre) is transferred to the supplier. This could be by way of a sale or a lease (in which case, of course, the supplier has to pay for it). It is not unusual in these circumstances for the negotiations around the cost of the real property to take a substantial portion of the total discussions.

Very often the customer looks to make a cash windfall in these circumstances. The cash from the letting or sale is sometimes ploughed back into the outsourcing to offset its costs. More frequently it is deployed to increase the customer's "bottom line" profitability.

Some very enterprising customers make judgement calls as to whether their premises will be valuable to the supplier as a facility for many of its customers (rather than just a dedicated facility for one). In this case, I have seen customers demand (and get) a premium for the premises in question.

If the customer's premises are not in the equation, then the supplier will need to allocate part of its own premises either on an exclusive or shared basis to the customer. These premises charges are then amortised into the standing charge that the customer pays the supplier. It may be that the customer is able to negotiate a lower cost for use of these premises if they are shared with other customers.

As an aside, the fit out costs for the premises that are chosen can also be quite substantial, depending on the nature of the services to be provided.

• Staff (Acquired Rights – "TUPE")

A hugely important consideration when pricing up an outsourcing deal is also the human resources cost. In Europe, the Acquired Rights Directive applies. This operates to maintain the continuity of employment of staff who transfer from the customer to the supplier on an outsourcing deal, unlike the position in the United States where employment is at will. The Acquired Rights legislation provides that the supplier needs to maintain the salaries and other benefits of the transferring employees at the same levels as they were immediately prior to the transfer. A failure to do this could render the supplier open to legal action by an aggrieved employee.

Another major consideration in relation to the transferring staff is that generally speaking, suppliers tend to be able to rely on economies of scale when running IT services. This means that they generally do not need as many dedicated staff to run the services for the customer. Inevitably, if the staff that transfer cannot be redeployed into other projects for the supplier, they will need to be made redundant. Very often the customer offers the supplier indemnity coverage against this possibility. It is customary for a "pot of money" to be included to allow redundancies to be made. Of course, if the customer is unwilling to do this, they may find (other than trenchant opposition from the supplier) that the costs are recouped indirectly through the "standing charges" that we mentioned earlier.

• Hardware and other equipment (repurchase/acquisition/installation)

It is very common to find that the existing or "legacy" hardware being used by a customer has depreciated to nothing and is effectively redundant: in many cases customers are outsourcing to achieve a "best of breed" replacement – engaging the supplier to undertake a wholesale technology refresh. In these cases the legacy estate is worthless. However, in some cases where the customer's technology is relatively new and still has some inherent value, the customer may seek further "bottom line advantage" by getting the supplier to buy the estate back from it.

I have been involved in a number of deals where the customer has sold its desktop estate to the supplier and leased it back. The customer gains effectively two advantages with one fell swoop here: a cash injection from the supplier and the removal of heavily depreciating assets from its books

• Software acquisition and licensing

It goes without saying that software costs are a major item in most outsourcing deals – particularly if an ERP or CRM solution is being deployed by the supplier as part of the outsourcing deal. The route to acquisition of the software is often extremely important: any sensible customer will want to take advantage of the supplier's economies of scale and piggyback off the supplier's existing relationship with the software vendor, rather than pay "retail" prices for the software which can often prove to be very expensive.

• Supplier "internal overhead" (management, contingency planning/DR, own premises, compliance)

Finally, in this category, customers need to be mindful of the supplier's own cost of doing business. Some suppliers will have considerable overhead (in the form of management/staff costs, premises and contingency planning) all of which will be amortised into the standing charge. Very often it is difficult for customers to get adequate breakdowns from suppliers as to individual amortised line-items, however it pays to be mindful to these cost pressures. A customer for example who insists on the services being provided from the supplier's premises in London will inevitably pay a much higher overhead than one who is willing to locate the services to Manchester, or even Mumbai.

Service Levels

During the "steady state" phase, the provision of the service itself will have cost implications. The Service Level Agreement, in particular, which defines the standard and quality level of the services provided will have a cost attached to it. The simplest metaphor, and one which is readily recited in this context is the customer that pays more for a "Rolls Royce" service, as compared to the customer who is prepared to settle for a Ford Mondeo.

Again, I may be stating the obvious, but it is surprising how many customers do not realise that by demanding "bells and whistles" – extra service availability or higher levels of service, that these will cost more for the simple reason that more resource needs to be deployed in order to attain them.

• Service Credits

As a subsidiary point to the one on service levels, a service credit regime can sometimes have cost implications for the supplier. These are basically credits against future bills made by the supplier to the customer in circumstances where the services set out in a service level agreement have not been met.

They should never be treated as a profit generation mechanism by the customer: they are designed simply as a sharp "stick" with which to prod the supplier. If they are turned into anything more than this then (if you are lucky enough to get the supplier to agree to them) you are likely to find that they are priced into the cost of services by the supplier.

Exit Costs

The costs of exiting from an outsourcing deal should also be very carefully priced in. As there is a high level of up front cost which is borne by the supplier then, as we noted above, it is highly unlikely that the customer is going to be able to walk away from the deal without some form of recompense to the supplier.

In outsourcing parlance, we refer to this as a break option. A break option allows the customer to terminate an outsourcing deal early upon payment of a break charge.

The break charge represents accelerated payment of the costs of the supplier in running the deal that would have been charged to the customer over the unexpired portion of the term that would have run had the deal not been ended early. As you can imagine, there are a variety of methods by which a break option can be calculated, however the most common is by a simple reducing scale: that is to say the charge is very high at the outset of the deal (reflecting the correspondingly high level of costs which have yet to be amortised) and flattens to zero at the end of the deal (reflecting the fact that the costs have been fully amortised).

Even where the deal ends "on time" by simple expiry of term, there will still be costs that need to be factored in and borne by either the supplier or the customer, as I note below:

• Premises

As on entry to a deal, there will be premises costs entailed on exit. If premises have been leased by the supplier, it may be that there will be early termination charges to pay to end the relevant lease (very often these are factored into the break charge that we discussed earlier). Leaseholders may also require that the premises are restored to the condition that they were in prior to the lease commencing, which can be quite a substantial cost. Even if the premises are owned by the supplier, there may well be costs entailed in re-commissioning the space used by the customer for other customers.

• Staff

As we mentioned earlier, the Acquired Rights Directive in Europe will also apply on exit of the deal to preserve the continuity of employment of the service staff as between the legacy supplier and any successor supplier (if the services are being transferred to a new supplier) or the customer (if the services are being transferred back in house). The same cost considerations will apply in these circumstances as were discussed previously.

• Hardware

Hardware may need to be decommissioned and or moved to a new location – referred to in the trade as "lift and drop" (this can prove to be a logistical nightmare if the systems are large mainframe or midrange AS400 computers). Desktop computers are obviously easier to move but present other challenges, such as tracking or auditing (or making certain that all inventory items have been collected and moved). Sounds simple, but in a very large outsourced enterprise with hundreds of staff walking out with laptops and taking them over the globe, it can prove to be quite challenging !

The costs for any such decommissioning and relocation will obviously need to be factored in, and will almost certainly vary depending on local factors such as how and where the decommissioning and relocation will take place.

• Software

Where third party software licenses have been obtained, the supplier will have attempted to align those licence terms with the term of the outsourcing agreement. Sometimes however (and especially where the deal is terminated early) the supplier is left with what are called "hanging licenses" (where the unexpired term runs beyond the end date of the outsourcing). The cost of these "hanging licences" needs to be priced into a final termination charge or the break charge as applicable.

Finally, before we discuss pricing models and methodologies proper, it is worth just covering some miscellaneous items which also may have significant impact on the costs charged by the Supplier and hence may flow into the pricing model.

Contractual Risk

The first of these is contractual risk. Most suppliers have standard form contracts which represent their optimal means of doing business. They will have priced up services on the basis that their risk exposure is as reflected in their standard terms.

I am not proposing to cover whether or not those standard terms are reasonable, because as we all know, such terms and conditions can range in reasonableness from mild (very reasonable) to extreme (totally unreasonable) – that is a topic for another article.

However, what the buyers of outsourced services need to understand is that in seeking to provide a watertight agreement which represents their interests (an admirable goal in any event), they may, if they push risk too far into the supplier's camp, be inadvertently increasing the cost of the services to be provided. I list some typical contract "flash points" below:

• Indemnities

We all understand that indemnities in an agreement amount to contractual promises to pay that obviate the requirements of breaches of warranty (that is to say proof of loss and damage). They are very convenient mechanisms for the recovery of losses in certain circumstances. However, if there are too many in favour of the customer (ie which can be called against the supplier) they may alter the supplier's risk profile for the deal and hence increase the cost.

On a very simple and basic analysis, they are likely to statistically increase the chances of the customer successfully recovering from the supplier in a default scenario.

• Insurance

Seemingly an innocuous clause, but very often the subject of contentious discussions. This is because there is a real cost attached to the provision of insurance. Many customers unwittingly also demand things that in practical terms can be very expensive to achieve, such as bespoke insurance policies specific to their service, or notations and/or expressions of interest on policies of insurance in an attempt to prioritise their business over others in a claim scenario.

• Limitation of Liability

The most obvious area in an agreement which defines the potential risk exposure of one party to another is the limitation of liability provision. The parties need to think very carefully about appropriate limits, and whether coverage for loss of profits and/or consequential loss is required. Again, it pays to understand that although a large and broad limitation of liability provision may be desireable for many reasons, it may have cost implications which flow into the ultimate price paid for the services.

Customer Credit Risk

The customer's own credit rating and profile will have an immediate bearing on the price payable – it is an absolute certainty that the chosen supplier will have examined this very carefully. It will be aware of the customer's past trading history and will know whether the customer is profitably trading or not. Again, a history of unprofitable trading; a poor credit rating or a poor reputation in terms of supplier payment and default will all push the supplier into a far more conservative place in relation to pricing a potential deal.

The lesson to be learned is that the customer needs to be mindful of its own desireability as a customer, as this will indirectly influence its ability to negotiate on price and cost.

Market Risk

To complete the picture, both parties will need to be mindful of "market risk" that is to say the macro environment from which the services will be provided. Pushing services offshore into countries that have inherently lower cost bases may have an immediate "bottom line" depressing effect on price, but the parties ignore at their peril any geopolitical factors which may have a destabilising effect on the territory. No one would seriously consider locating a shared service centre in Iraq at this present time, so this is a rather extreme example, however, hopefully it illustrates the point.

Cross Border Considerations

Taking aside the geopolitical considerations mentioned in my last point, offshoring services will obviously influence the cost paid for the services. The customer needs to enter into any such offshoring proposition with their eyes open and having undertaken a thorough due diligence. Hopefully you will have learned from the preceding points that pricing an onshore outsourcing can be a difficult enough exercise without taking into account local market sensibilities and cultural considerations. I don't propose to dwell on these in any great detail, however there are a couple of areas which are worth flagging.

• Cost of Labour/Resources

A typical motivator for an offshore outsourcing to jurisdictions such as India, China and the Philippines is the expectation that staff salary costs will be lower and that this will lead to lower costs (as compared to running the service with employees located in "first world" countries such as the United States and those within Europe). This will almost certainly be the case. However the customer will need to be very careful that these labour cost gains are not swamped by other cost items that are necessitated by the offshoring, such as for example, long distance voice and data communications links between the customer's premises and the remote location; or indeed (as happens quite frequently) the cost of senior management flights between the two locations.

• Cost of Currency (Currency exchange risk)

The final point that is worth mentioning is the issue of foreign currency arbitrage in cross border deals. It is very important that the customer and the supplier understand what currency the deal is to be priced and invoiced in; and in what currency the costs and overhead are to be settled. A failure to understand and plan for this can lead to catastrophic problems. I have had personal experience dealing with a very large banking customer operating in Poland who was downselecting to two shortlisted vendors in a big outsourcing. One of the shortlisted suppliers had essentially forgotten that whilst the deal was to be invoiced and paid in Polish Zlotys; all of the hardware and software infrastructure had to be purchased in US Dollars. They had neglected to take account of the currency fluctuation risk and had no US Dollar foreign currency reserves. The resultant uncertainty (and volatility in international currency markets at the time) meant that they could not commit to a definite price for the hardware and software and had to drop out of the bidding process.

1. Pricing Models

So we have considered in the round the factors that have a significant impact on deal pricing. Hopefully this will enable you to put the particular pricing methodologies, which we will now discuss, into context

Pricing the deal – Pricing Methodologies