Getting the most out of outsourcing
August 2013 | 10QUESTIONS | BOARDROOM INSIGHT
FW speaks with Andrew Dunlop, a partner at Burges Salmon LLP, about outsourcing business activities.
FW: Could you provide a brief overview of recent trends in outsourcing business activities to third parties? In your experience, are more companies exploring this strategy for their business?
Dunlop: Vanilla off-shorings and consortium deals both seem out of favour. The former because price differentials through labour arbitrage are reducing and the latter due more to a perceived ‘muddying of the waters’ with associated lack of accountability; global deals with prime contractors as a single point of responsibility are more in fashion albeit more often evidenced through multi-country arrangements between customer group and vendor group under an over-arching ‘grandfather’ master contract. Increasingly, outsourcings are being tendered competitively in contrast to the single source arrangements seen in previous years but to a limited shortlist of perhaps only two or three separate vendors. Cost, although relevant, is not as much of a driving factor as the push towards ever greater efficiencies through outsourcing involves increasingly complex solutions in contrast to vanilla outsourcings of previous years that focused solely on labour arbitrage.
FW: What are the key reasons for outsourcing business activities? What advantages does the process offer?
Dunlop: It may be cheaper to have a third party provide the outsourced business activities and the move from capital expenditure to revenue expenditure can be attractive to the corporate balance sheet. New management often brings a new perspective or is prepared to embrace relatively new management tools such as outsourcing; senior executives that have been through the outsourcing process before commonly wish to revisit the benefits and continue to outsource in the future – for example, to achieve improved performance, reduced or shared risk, enhanced flexibility or access to new skills and training. A project may be too complex to be undertaken by the customer in-house in the midst of every day operations without outsourcing. Growth also acts as a natural driver to outsourcing as a means to ensure customers can invest in opportunities to grow without simultaneously needing to invest in developing expertise in ancillary non-core processes.
FW: In your opinion, do particular industries or sectors lend themselves more readily to outsourcing business activities? What kinds of processes are inadvisable to leave in the hands of third parties?
Dunlop: Subject to compliance with limited restrictions on access to strategically important governmental information, outsourcing can be applied to almost any activity. There is no one-size-fits-all. Process mapping can help; organisational activities can be deconstructed into their constituent business processes and analysed function by function to determine whether external experts in that process can do it faster, cheaper or better. While organisations tend to start their outsourcing programmes with clearly non-core ancillary processes such as cleaning and IT helpdesks, the trend in recent years has been to increase return on investment through ‘moving up the food-chain’ and looking to outsource combinations of all types of activity other than the strategic direction and management or ‘brain’ of the organisation. More usual outsourcing examples include financial and accounting processes, HR, payroll, invoicing, recruitment, knowledge management, facilities management, data centres, infrastructure, desktop, business transformation, manufacturing, supply chain, delivery and collections.
FW: Companies may use outsourcing as a mean of plugging ‘talent gaps’ within their own organisation. What advantages does outsourcing bring over employing such talent in-house?
Dunlop: Employees are protected by labour laws and cannot readily be dismissed or made redundant in Europe without following due, and potentially costly, process and with associated, and potentially hefty, termination payments. So, hiring an employee becomes in itself a complicated exercise designed to minimise the risk of hiring a candidate who later proves unsuitable. In contrast, outsourced talent can be ‘picked up and put down’ instantly, replaced or substituted as desired merely because of changing requirements or because the talent is thought unsuitable or a preferred alternative presents itself. Similarly, the talent can be ‘let go’ once the ‘job is done’ and the organisation does not pay for holidays, sickness, ‘no shows’, variable performance or for employee or personnel tax associated with the talent – although VAT if chargeable erodes this particular differential.
FW: What risks are commonly associated with outsourcing and what steps can firms take to mitigate these risks?
Dunlop: Institutional resistance can be an issue, if parts of the organisation feel adversely affected or a loss of control of strategic operations. These fears do not generally survive detailed analysis of the benefits comprised in the business case for the outsourcing. Documenting the customer’s business objectives scope, service levels and pricing mechanisms is vital. Failure to align the arrangements with the customer’s objectives may mean that it believes it is buying a particular service when the vendor is delivering a different service altogether. Similarly, the customer needs to understand the vendor’s aims for the proposed outsourcing relationship. Is the vendor’s biggest concern to meet or improve operating margins, increase even at the cost of buying market share, acquire valuable skills or technology, or gain follow-on work or a strategic relationship? Contracting within these aims increases the probability of a ‘win-win’ relationship as well as reducing the risk of subsequent interpretative disagreement.
FW: What are some of the main regulatory and legislative concerns that might surround an outsourcing agreement?
Dunlop: Outsourcings are impacted by key regulatory and legislative concerns wherever they involve assets, contracts, information, software, real estate or people. People or ‘human resources’ may transfer automatically under the EU Acquired Rights Directive irrespective of the wishes of vendor or customer. Land transfers or leases may require landlord consents, registration or formal documentation under national laws. Cross-border consents may be needed to enable both parties and their respective groups to use patents, copyright, databases and trade secrets or other confidential information in software, databases and other information belonging to third parties. Information flows have a regime all to themselves; namely the EU data protection regime, which imposes structural constraints and process requirements on any outsourcing that, broadly speaking, involves access to or the export of data relating to living individuals on behalf of a customer established in the EU – or using computer systems based in the EU.
FW: What steps should firms take when drafting an outsourcing contract with service providers? Are any key considerations often overlooked?
Dunlop: Precedent contract clauses are readily available if not necessarily tailored to any particular outsourcing. The real key to drafting an outsourcing contract, however, is to develop inter-related descriptions of the scope, service levels and pricing. Each of the service offerings or towers must be clearly described including all of the specific activities that fall within each of those areas where outsourced. If a service is not described, the vendor is not obliged to provide it. Service levels need to cover all key aspects of performance including targets, commitments and reporting mechanisms based on end-user expectations rather than historical statistics that are adjusted periodically and continuously improved. Pricing and payment can then be linked to these service levels or other success features such as achievement of measurable objectives making use of techniques such as gain-sharing, payment milestones, bonus incentives and payment decay for delayed fulfilment.
FW: Briefly, could you explain competitive benchmarking clauses? Why are these important, and how should such clauses be structured?
Dunlop: Technology requirements cannot be forecast with accuracy far into the future, and the customer’s position may change with new service lines, products, markets and demands. Early termination for default or by operation of a break-clause is necessarily disruptive in comparison to a scheduled expiry date. In contrast, a benchmarking mechanism can reset pricing and quality without fuss, allowing for external experts agreed by the parties to benchmark against pre-set criteria that determine what can be disclosed and measured – and against what – over what timescales, and the date from which the reset pricing and services apply. Working examples are usually accompanied by a control mechanism to override disagreement between the parties as to the identity of the bench-marker, what can be benchmarked, by reference to what, what happens if the benchmark results are disputed and the effect of the benchmark results on the period to which they relate and the future.
FW: What measures can parties take as a contingency to disputes arising down the line? Do firms place enough emphasis on dispute resolution clauses within the original outsourcing agreement?
Dunlop: Commercial position should not be used as a weapon by either side. For the customer, this would mean an unwarranted withholding or threatened withholding of price. For the supplier, this would mean an unwarranted withholding or threatened withholding of performance. In the event of a dispute, service continuity is essential while the process for resolving disagreements is in train. Often the process allows for the customer’s position to be automatically preferred in the interim because of the greater relative impact of non-service on the customer in contrast to non-payment on the vendor. The process itself is commonly part of relationship governance, allowing for the parties to escalate discussions to higher but equivalent management reporting lines within customer and vendor within set timelines before ultimately directing unresolved disputes to an appropriate third party. This is often arbitration at a recognised neutral arbitration venue while domestic outsourcings may prefer recourse to the domestic courts.
FW: What options are available to parties if they are unhappy with the outsourcing service received?
Dunlop: Ideally the parties would seek to reduce the risk of discrepancy between the expected relationship and the outsourcing service received by documenting service commitments in a full scope of work before service commencement, and with success ‘measured’ through performance criteria linked to that scope. The parties may build in ‘coming up for air’ provisions along the term of the relationship that permit exit on notice if the parties cannot refine a more acceptable alternative without the need to show breach and avoid termination fees, and the potentially unpleasant apportionment of blame. Contracts commonly also include yellow card and red card warning systems such as service improvement plans or corrective action notices that ultimately empower unhappy customers to price adjust, restructure, self-help, de-scope or exit an outsourcing arrangement. Technical differences can be diverted to independent technical experts with a mandate of finding a mutually acceptable solution with costs shared between the parties.
Andrew Dunlop is a partner and head of Burges Salmon’s Technology and Outsourcing practice. He acts for clients in both the private and public sectors specialising in the development of integrated business, legal and technical solutions. He was the sole lawyer on the City Financial, Insurance and Assurance Working Group dealing with outsourcing issues for City of London financial institutions between 2005 and 2007, and the international director of the National Outsourcing Association between 1998 and 2012. Mr Dunlop speaks regularly on outsourcing transactions at conferences. He can be contacted at +44 117 902 2786 or at firstname.lastname@example.org.
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