UK: Securing The Benefit Of Innovation In Outsourcing Arrangements

Keywords: pricing models, outsourcing models

Innovation is a high-value topic now. In some sense, the customer in an outsourcing arrangement is always looking for innovation. In response, suppliers both innovate and adopt innovations made by other companies. Often, the "innovation" will be the ability to provide more economic, useful or resilient service than was originally promised. In exceptional cases, innovation creates opportunities to deliver entirely new insights, products or services.

Cloud computing has spawned a burst of innovation relevant to outsourcing. For example, cloud computing provides the processing power for innovations such as big data, cognitive computing, robotic process automation, the Internet of Things and "as a Service" products. Many of the innovations spawned by cloud computing can be applied to improve outsourced functions in ways that reduce cost while holding steady or even improving service performance. In addition, increasing amounts of second-stage outsourcing means that customers are seeking productivity gains beyond those that can easily be anticipated from the consolidation, sourcing or offshoring of a function.

So, the question becomes, how can customers secure the benefits of innovation?

Traditional Outsourcing Models

Traditional outsourcing pricing models do not naturally drive the benefits of innovation to customers. Where the customer pays for inputs such as FTEs or machines, the supplier has an incentive to avoid innovations that would reduce the quantity of those inputs. Where the customer pays based on the number of activities performed, the supplier captures all reductions in its cost of performance. In each case, there is a chance that the supplier could improve its profitability through innovations that reduce its cost but increase risks for customers.

In addition, the traditional outsourcing model tends to involve a promise to deliver services at standards that are being attained or are clearly attainable at the signing. Thus, the supplier has the ability to win the lion's share of the benefit of any innovation by offering improvements only at an additional charge. Some outsourcing agreements include glide paths or other automatic mechanisms, but those generally provide customers only what was foreseeable in an earlier competitive bidding process, not what is delivered in the burst of innovation that we are seeing today.

Suppliers often claim that market forces drive them to continuously innovate and improve.

However, in the traditional outsourcing model, early termination fees create barriers to switching suppliers. This reduces the incentive for a supplier to provide innovations to existing customers on the theory that doing so would cannibalize existing committed revenue (although the supplier might offer innovations to win new customers).

General Innovation Covenants

It is quite common for outsourcing arrangements to include an express commitment by the supplier to deliver innovation. Similarly, customers often have rights to "roadmap" briefings and to be offered a chance to be an early adopter of innovations. Frequently, a customer will negotiate the right to participate in development forums and the like to help influence developments by the supplier that could benefit the customer.

Whether these mechanisms ensure that the customer gets "enough" innovation or a "fair" share of any resulting innovation is something of a mystery. The supplier certainly acquires know-how from the customer (and other customers), and it develops its skills in delivering its services at the customer's expense.

Quite often, the customer makes further, specific investment to participate in the supplier's development process. The customer's "benefit" is in getting a service that may be more specifically tailored to its developing needs. The customer may also benefit from having the supplier's investment in innovation being spread across its entire customer base. In the absence of a gain-sharing methodology, though, it is not easy to see how the customer gets a direct financial benefit from the gains the supplier makes as a result of innovation reducing the cost of delivery of services in the traditional service level and input-based changing model. These gains might well be material.

Somewhat paradoxically, customers often seek a share of gains from innovation through covenants that prohibit innovation. For example, outsourcing arrangements commonly prohibit suppliers from subcontracting work without consent. While these covenants can reduce the risk that cost-reducing innovations for the supplier will increase customer risk, they also allow the customer to negotiate for some share of the benefits of approved innovations. The roundabout nature of the protection is unlikely to provide a full or fair share of the benefits to the customer.

Bespoke Innovation

There are also difficulties in assessing whether the customer gets a fair share of the gain that the supplier derives from bespoke innovation, that is, innovation made specifically for an individual customer at that customer's cost. Bespoke innovation reliably produces innovations that conform to agreed specifications. The challenge, however, is that the customer may share little or none of the value that the innovation brings to the supplier. Often, the customer contributes not only funding but a great deal of market, technical and operational information.

The customer will often negotiate some form of exclusivity in bespoke innovations. While the customer still may not receive much of the benefit that the supplier receives, the exclusivity can protect the customer from having competitors benefit from cloning the innovation in their own operations. It seems unlikely that the supplier and the customer will negotiate a deal at the time the innovation is ordered that fairly reflects the benefit each party might derive from the innovation. While this is a common problem in any innovation arrangement, the long-term relationship between the customer and the supplier does raise the question of whether there are alternative models that might reward each party more equitably for their respective investment in the innovation by referencing the benefit in fact derived from the innovation. One such alternative model is outcome-based pricing.

Outcome-based Pricing

In an outcome-based pricing model, the supplier is paid based on the benefit that the customer derives from use of the supplier's services. For example, a supplier of accounts receivable administration services might be paid based on how quickly it collects amounts due (that is, on days sales outstanding) instead of on the number of FTEs administering receivables or the number of invoices sent. A supplier of procurement services might be paid a "gain share" based on a share of savings achieved. A supplier of bespoke innovations might be paid a share of the revenues from reuse of the innovation.

Outcome-based pricing models work by aligning the interests of the customer and the supplier. The supplier gets paid by reference to gains made by the customer. If the supplier is more efficient at delivering the outsourced service, then, in theory, the customer's business would be more profitable. If structured well, this model can incentivize a supplier to drive gains through innovation over an extended period. In addition, if the incentives are well-aligned, the contract needs fewer restrictive covenants and requires less control-oriented governance.

Outcome-based pricing benefits greatly from an initial investment in deal structuring. This investment is larger than that required to merely replace one set of inputs with another set of inputs. The challenge is to define measurable outcomes that can be attributed to successful innovation. In doing so, the parties work to exclude the effects of factors outside of supplier's control. For example, a customer might use days sales outstanding compared to an industry average instead of the customer's historical days sales outstanding so that the supplier's compensation is based on its efforts, not changes in general economic conditions or improvement measured from an inefficient internal metric.

There are, of course, risks in outcome-based pricing. The supplier may impose unanticipated costs and risks on the customer as it pursues the selected outcomes or may be compensated for lucky results instead of genuine effort. The customer's strategies may shift, making the outcomes less valuable. The supplier's scope might need to be expanded to give the supplier adequate control over an outcome. However, balanced against a likely lack of fairness in the division of benefits from innovation in conventional input-based pricing, the risks in outcome-based pricing for elements of a deal that involve innovation commitments do not look insurmountable.

Conclusion

Traditional outsourcing models are not well-suited to delivering the benefits of innovation to customers. In this time of rapid innovation in technology that delivers outsourced services, customers who are willing to make the initial investment in structuring outcome-based pricing strategies can secure more of the benefits of an increased flow of innovations.

Originally published in Business & Technology Sourcing Review Issue 22 | Fall 2015

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