Suppliers of outsourcing services deliver products and services more efficiently than the buyers of these products and services.
This is a fundamental assumption that forms the basis of the value gained in an outsourcing arrangement by the buyer of these services. The ability to ‘buy’ cost savings and efficiencies (in addition to many other things) from the supplier is the central benefit of outsourcing. However, a reduction in financial risks does not mean that the operational risks also diminish. It is this special relationship between the risk categories that becomes the central theme in Section II of this book.
The incentives for outsourcing suppliers are the increased margins and competitive advantage over competing supplier organizations. The need to perform at higher standards in terms of speed (volume output), cost of work done (cost of production) and quality of products/service delivery means that the supplier must innovate and perform better than the organization or buyer of these services. The risks of innovation must be considered by the supplier. What are the effects of this on the buyer’s risk profile?
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A supplier of services needs to cater to the needs of the buyer.
The buyer of outsourcing services clearly seeks to derive maximum value directly through the outsourcing services and the positive effects the services would create in the various parts of the organization. While the supplier has profit motives, it seeks also to provide increased value to the buyer. It is demonstrated, however, that the value, in terms of goals and risk carried by the buyer and supplier, do not match. This produces a tension that is neither conducive to either group nor to the ideals originally designed to be delivered by strategic outsourcing. The risk profiles of both the buyer and supplier obviously change.
A further development has been that leading corporations acknowledge that the top tier of outsourcing organizations cannot be ‘the best’ in all areas, and hence have been contracting with two and/or a network of suppliers who are expected to co-operate in order to deliver a seamless service on behalf of their clients. Environmental and organizational risks are considered in this scenario.
The objectives of a typical outsourcing arrangement can be contractually specified. Methods and processes are, however, difficult to incorporate if they are based on tacit knowledge. Tacit knowledge is the result of an accumulation of experience and, as such, may be difficult to communicate to those without equiva-lent experience. Since contractors control work processes, unless they share the required tacit knowledge, they may choose suboptimal processes. Addressing this limitation may require intense day-to-day involvement of the organization’s managers with the HR contractor until the contractor acquires the requisite tacit knowledge. Inefficiencies are likely to result, however, because managers may lack specific authority to direct work processes of contractors. Thus, because many positive HR outcomes depend on tacit knowledge, organizations that believe they have achieved such outcomes with in-house HR management are less likely to rely on HR outsourcing.
1.12
Outsourcing contracts
Effective contracting reduces the probability of many potential sources of loss. This serves to control legal risks. Unanticipated environmental changes create unanticipated opportunities for exploitation that were not protected against in the outsourcing contract. The probability of losses from residual risks is also determined by the unquantified probability that outsourcing partners will see and exploit these opportunities.
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Common Terms and Concepts Used in Outsourcing Contractual and/or informal relationships between the supplier and buyer organizations of these services are often structured around the nature of the outsourcing contracts and the use of market opportunities for competitive advantage. The various attributes of outsourcing contracts in the different types of outsourcing agreement vary. Outsourcing uses contractual mechanisms to help manage unique requirements and closely interlinked processes.
There are significant differences between the attributes of a sourcing contract and those of an outsourcing contract. However, various features encompass the contract mechanisms for both these concepts. When the price of the services is considered, often there are no ‘market rates’ for long-term contracts, especially with ITO, but often a negotiation process takes place. In an outsourcing deal, this is structured into a contract where possible formulae form the basis for pricing. In an outsourcing arrangement (versus a sourcing deal), the supplier typically is given a contract covering a long period of time (possibly 5 to 10
years) to deliver agreed outcomes over this period. In this instance there are high switching costs for both the buyer and supplier.
The services in a sourcing contract are tightly linked with the contract. When services are sourced (or purchased), the supplier provides the innovation, service and price at the time of purchase. In an outsourcing deal, the buyer determines the strategy, price, and contracted services that are delivered by the supplier.
The governance structure protects both the buyer and supplier in a long-term contract and agreement. During the outsourcing agreement period, the governance process allows for communications and an escalation process to resolve conflict. In a sourcing process, a supplier can be selected at any time.
Contractual risks are a dominant factor in the outsourcing decision. The drivers of risk derive from information asymmetries before contracting, inability to monitor partners’ actions accurately, and exogenous changes that allow one party to behave opportunistically.
Governance infrastructure that will be in place at the start of the outsourcing contract will ensure that contracts are administered and processes are in place. Service level agreements are put into place. Service levels will be defined by the business functions and avoid highly technical metrics, as is well understood by business managers. The service levels also have clear and agreed consequences associated with failure to meet minimum standards.
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The governance process ensures that the early agreements between the parties are adhered to. Finally, the customer’s changing requirements are administered during the term of the contract, through the governance framework. This ensures appropriate arbitration as the supplier is often reluctant to change the contract without concessions or price increases. It also protects the supplier from unreasonable changes by the buyer.
The following are some supporting contract-related issues and related risks as observed by various experts. Despite the need for a clear contract, it is important that both the buyer and supplier must be ready to modify their means and ends as the outsourcing relationship develops. Not all aspects of the contract are foreseeable. A lengthy legal contract is not sufficient to manage this risk and protect what can be billions of dollars invested over an extended period of time. As retrospective documents that impose penalties after the fact, contracts are not suitable tools for remedying customer satisfaction. The outsourcing process is more effectively controlled through requirements definitions and formal change management systems.
The risks associated with the relationships form a key characteristic of the outsourcing agreement. Contractual difficulties can be grouped into a number of areas, involving precontract information asymmetries of supplier quality, inability to observe counterparty action, and opportunistic behaviour enabled by the bilateral relationship in an environment of great uncertainty and biases against comprehensive risk analysis.
An outsourcing contract between two parties is dictated by an enforceable contract. ‘Contracts’ can take a variety of forms ranging from a spot market contract where the terms are established and immediately satisfied after entering the agreement (for example, to buy or sell an existing mainframe to a predetermined deadline), to a long-term relational contract which simply agrees on a set of rules for future conduct without being explicit about everything each party is to do in every contingency. The critical limitation of contract structure, whatever the form, is that contract terms need to be enforceable. This requires a higher threshold than merely being observable by a third party. Contractual terms must also pass the more rigorous condition that they are verifiable to an outside party such as a court.
There are a number of factors that influence the choice of governance structure. The ability to observe, monitor and verify the activities of both parties places restrictions on how detailed and effective an explicit contract can be.
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Common Terms and Concepts Used in Outsourcing 1.13
Outsourcing and the implications for
human resource development
Research shows that the success of outsourcing is more likely to be restrained by human rather than technological problems. In almost every situation where outsourcing is implemented, there is a reduction in the need for people. This often means that personnel are reassigned to another job function or are no longer needed in any capacity. These changes therefore often involve reductions in personnel in order to improve the efficiency of the organization in terms of cost disciplines and to maintain competitiveness in the market. The resultant organizational setup thus has both positive and negative consequences. Conversely, an ageing IT workforce is a factor for consideration in more mature markets (e.g. in North America) where retirements outpace the ability of governments to staff important technical functional areas.