Stay the course or start fresh? Outsourcing contract renewals poses dilemma

by Hack Heyward, Information Services Group

Utility executives face a dilemma when information technology outsourcing contracts come up for renewal. Operational continuity is imperative, so the idea of switching providers and risking service disruptions is unpalatable. Client organizations face significant and increasing pressure to demonstrate that the fees paid to third-party service providers are aligned with market standards. This raises the worry that renewing on existing terms, which might have reflected the market when put in place, can lock a customer into a noncompetitive agreement.

An effective end-of-contract strategy ensures that clients optimize the value of their outsourcing investments while maintaining high standards of service quality. Achieving this balance requires detailed understanding of existing operations, market standards and emerging trends, the ability to assess the implications of alternative scenarios, and the willingness and ability to change providers.

Baseline the Existing Operation

A quantifiable analysis of the operation prior to assessing end-of-contract options provides an essential foundation for defining options.

A detailed and specific benchmark of existing prices and service levels in the context of market standards identifies where a service provider’s costs are competitive and where gaps exist. The benchmark can be carried out through a contractual clause that involves the provider and a benchmarking firm or through a proxy pricing model applied by an independent third party.

If the benchmark shows that overall, existing prices are competitive and aligned with market standards, the focus of the contract renewal can shift to governance and performance issues, facilitating innovation or improving process efficiency. If the results show significant gaps, the client must determine if the needed improvements can be achieved with the incumbent provider or if a change in vendors is required.

Clear Goals

The ability to define objectives and expectations for the service provider is another key to an effective end-of-contract strategy and is necessary to ensure vendor solutions align with the client’s business strategy and risk appetite. Here, the benchmarking process is applied at a more granular level to assess options such as negotiating with the same vendor for the same services, negotiating with the same vendor for part of the services, bringing some services back in-house, or sourcing the remaining services to one or multiple vendors (see figure). Benchmarks similarly can be applied to assess whether maintaining geographically disparate data centers is more viable than consolidation.

These scenarios are analyzed with risk to determine the sourcing approach that best suits the organization’s needs. Rather than dictating how the vendor will deliver services, the client is the primary architect of the sourcing framework within which the vendor or vendors will work. By selectively isolating individual service elements, the client can consider a broader range of options. Summarily kicking out an entrenched incumbent vendor might be too expensive, disruptive and risky to consider, so identifying one service tower to rebid or repatriate could be feasible. Such a scenario is common. Major information technology managed services contracts traditionally awarded all towers under consideration to a single major service provider. As a result, a provider would accept responsibility for towers or service elements where capability was lacking.

This level of specificity extends to the client’s definition of services to be provided by the vendor or vendors. Roles and responsibilities should be adjusted from the existing model for each tower to reflect the planned expansion or retraction of services; the latter typically results from the repatriation of specific functions or a shift to a multivendor model.

From a pricing perspective, the baseline analysis is used to target towers or functions for adjustment. For example, rather than trying to negotiate across-the-board price cuts, the client can negotiate a 20 percent reduction in a service tower where existing charges are found to be above market standards. This ensures alignment of each service tower to the market. Because of the tendency to award all towers under consideration to a single provider, customers often discover that one service tower subsidizes another during the term of a contract. Service providers may cut pricing for areas where they are competitively weak and raise pricing in areas where they are strong or have unique capabilities. An effective renegotiation ensures each tower is within market standards, even if pricing in one tower increases so that the overall pricing decreases.

The ability to benchmark the pricing of outsourced services against market standards is an important tool utilities rely on to respond to regulatory demands to demonstrate that rate increases are justified and not used to subsidize inefficient operating practices. Specifically, Canada’s provincial regulatory bodies in recent years have implemented strict guidelines that mandate utilities prove the rates they pay to third parties are reasonable and competitive. Although the dynamics of the Canadian market are different, utilities are increasingly vigilant to ensure due diligence is conducted around the contract renewal process.

Senior-level Support

Boardroom objectives must be aligned with and communicated to the executives charged with implementing the end-of-contract strategy. Similarly, the executives who negotiate must enjoy the backing and support of senior management.

Alignment and senior-level support doesn’t happen on its own. The sourcing team must continually reassess its sourcing strategy against constantly evolving business requirements. This requires ongoing, two-way communication with the business to ensure the sourcing organization understands and delivers on strategic requirements. Through this process, executive-level support and buy in are earned rather than requested.

Gaining the confidence of senior management requires that information technology executives define the implications of operational scenarios and outline options that best align with business needs. For example, in evaluating an offshoring initiative, information technology executives should be prepared to outline scenarios and quantify the potential risks and benefits of each. This allows the senior executives to select an optimal course of action that combines a necessary level of cost reduction coupled with an acceptable degree of risk.

If the sourcing organization lacks senior-level support, the service provider potentially can circumvent the negotiation team and influence the renewal decision at the executive level.

Consider this scenario: Information technology executives work to negotiate changes and drive improvement at the end of a contract term only to have their efforts derailed by a “golf course deal” at the executive level. In many cases, the operational team can find itself demonized for addressing contractual issues and accused of disrupting the client-vendor relationship.

Be Serious

If the benchmark finds that the pricing and terms of the existing contract are unacceptable, the customer needs to demonstrate the willingness and ability to follow through and actually make a change in service delivery, whether by rebidding or repatriating individual service towers or in some cases replacing the incumbent vendor entirely.

Clients often overestimate their leverage in contract negotiations. They mistakenly believe threatening to repatriate or rebid services will yield significant concessions and improvements from the incumbent; however, absent evidence that the client has developed and is willing to pursue a viable alternative, service providers have little incentive to make meaningful price adjustments or commitments to improve quality. And if the client hasn’t prepared and planned for repatriation or a transition to a new provider, there often is little incentive to change.

In other words, incumbents tend to call the client’s bluff.

A common client tactic is to issue a request for proposal (RFP) and assume the incumbent vendor will respond with urgency and action. In reality, the RFP process often becomes an exercise in going through the motions. The incumbent vendor recognizes the client seeks to gain price concessions and will respond with some discounts and promises to address service issues without adequately addressing key problems. Bidders, meanwhile, often conclude there’s a minimal chance of wresting the business from the incumbent. As a result, they submit a suboptimal proposal. As the outsourcing industry has matured, bidders have become sophisticated and easily can convince an outsourcing customer that it is serious in replacing an incumbent, when really the bidders think they can’t win and simply are trying not to irritate a large enterprise by not bidding.

An effective RFP process demonstrates to the incumbent vendor and new bidders that the client is serious about considering changes and is prepared to pursue viable alternatives if requirements are not met. A key client responsibility is to ensure fairness among prospective bidders and to demonstrate this commitment through actions. When an RFP is issued, the incumbent vendor generally enjoys an advantage: knowledge acquired from the client’s environment. To ensure a meaningful review process that produces an optimal range of alternatives, the client organization must provide ongoing guidance and detailed information to all bidders. This, however, can require significant investment in internal resources. If this investment isn’t forthcoming, prospective bidders will conclude the client isn’t serious about making a change and will respond accordingly. Executives must actively lobby prospective vendors to convince them they are serious and that participation in the process is worth their while.

The effective way to convince bidders a client is serious about change is to inform the incumbent service provider and prospective replacement bidders that the incumbent will not be allowed to bid. This is difficult for a client to stick to and often is not done, but if a client knows the incumbent cannot close the pricing or performance gaps, it can be the best way to ensure prospective replacement bidders pursue the opportunity seriously.

Author

Hack Heyward is a director with Information Services Group who specializes in utility issues. ISG is a global consulting, research and managed services organization.

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