Let's talk .....the Outsourcing Lifecycle

This Article introduces outsourcing deals and covers the following aspects of the lifecycle of the typical outsourcing transaction, primarily from the customer's perspective:

• Characteristics of outsourcing deals
• Why organisations outsource
• The lifecycle of a typical outsourcing deal
• Analyse requirements
• Scope project
• Commercial considerations
• Technical considerations
• Regulatory impact
• Deal structure
• Offshore/near shore and cloud services
• Procurement process
• Selection and contract
• Delivery and contract management
• Contract end/renewal

The outsourcing process is often complex but provided that it is approached systematically with clear goals in sight, it can be managed in an orderly way. Taking a structured approach enables customers to have realistic objectives, establish how to measure the achievement of those objectives and then contract on a basis that will allow those objectives to be met.

Characteristics of outsourcing deals

An outsourcing deal involves the transfer of the responsibility for delivering a service to an external provider (or from one external provider to another).

Outsourcing deals are more complex than straightforward contracts for the supply of goods or services as they often involve the transfer of people, assets and contracts as well as the service provision.

Having transferred the service provision and any related people, assets and contracts, the outsourcing contract will provide for:

• the buy-back of the outsourced services by the customer
• the ongoing management of the supplier and of the provision of the service, and
• the usual array of contractual protections around termination and exit, liability, quality etc

Outsourcing agreements tend to be longer in duration than standard service agreements (typically three to seven years) to allow sufficient time to transition existing services, undertake transformation, and enable the supplier to recover their initial investment.

Outsourcing is now a common business model and, as a result, many deals are often re-tenders of existing outsourcing (‘second-generation’ outsourcings) and are sometimes in-sourced back to the customer. ‘First-generation’ outsourcings, where a function is outsourced for the first time, are increasingly rare. Accordingly, the outsourcing agreement should include provisions to accommodate both a further generation of outsourcing and for the service to be brought back in-house by the customer.

An outsourcing can be for the supply of any goods and/or services although they tend to fall into one of two categories:

• IT outsourcings (or ITOs), where a customer outsources the supply of IT equipment and services, and
• business process outsourcings (or BPOs), where a customer outsources the supply of internal business functions such as finance and HR or other functions or compliments existing functions.

However, business process outsourcings will often have a significant IT element (e.g. a customer may outsource their IT service desk alongside other functions and/or there will be significant use of technology by the supplier to provide the outsourced service), so hybrid outsourcings are increasingly common.

As with any arrangement for the supply of goods and/or services, an outsourcing can be for the benefit of a single entity or group of entities. However, it is very common for a single customer to procure an outsourced service on behalf of its corporate group.

Why organisations outsource

Organisations choose to outsource for a variety of reasons. While cost can be a driver, it is only one of many. Key reasons why organisations outsource include:

• cost reduction
• improved performance
• access to best practice and expertise (including regulated sector expertise for regulated organisations)
• ease of scaling requirements (up and down)
• fixed (or at least more certain) pricing
• better use of management resources
• financial engineering (eg moving costs from capital expenditure, such as investing in new IT equipment, to operational expenditure, such as paying quarterly for IT services that involve the supplier purchasing new IT equipment),
• consolidation, harmonisation and/or transformation (e.g. of services, assets, contracts and/or processes), and
• improved security and resilience (at least in principle, as the supplier should have specialist expertise in providing such services)

Ultimately the organisation seeking to outsource must be clear on the strategic objectives to be achieved by the outsourcing and how to assess the benefits and value of the outsourcing arrangement.

It is essential that having made the decision to outsource, organisations approach the procurement and contracting process in a manner that will enable them to achieve their objectives both by:

• contracting with the supplier offering the best overall value for money and service quality (depending on an organisations objective, this may not be the lowest priced offering), and
• ensuring that their contract contains the mechanisms that will try and ensure that the chosen supplier meets those objectives.

The lifecycle of a typical outsourcing deal

The lifecycle of an outsourcing involves a number of stages and is often a fairly lengthy process (although, with the increased prevalence of outsourcing as a business model, these timescales are shortening). It is important, wherever possible, to allow sufficient time for each stage so that the customer achieves a deal that enables it to achieve its objectives with a supplier that is able and incentives to deliver on those objectives.

Unlike many transactions where, following signature, one party has an asset or the benefit of a one-time service provision and the other has cash and they go their separate ways, an outsourcing agreement marks the start of a relationship. The relationship will continue to evolve and will eventually end, to be replaced by a new relationship with a new supplier, a renegotiated agreement between the existing parties or the customer taking the service back in-house.

The lifecycle of an outsourcing deal is illustrated in the following diagram:

The following sections summarise the key considerations to bear in mind at each stage of the outsourcing lifecycle.

Analyse requirements!

Before embarking on an outsourcing project with all the costs (in terms of external advisers and internal management time) and risks involved, it is crucial that the customer carries out a careful internal business analysis of:

• what it is seeking to outsource
• why it is proposing to outsource it
• what it sees as the gains it wishes to make (be they technical, financial or otherwise), and
• how it will measure those gains

In doing this, the customer must seek to obtain input from and align the interests and expectations of the various stakeholders in its organisation. These will range from board-level sponsors of the project to managers and teams whose interests and operations will be affected by the project. The customer may involve external advisors with experience of doing so to assist with this.

The outputs of this process will inform the rest of the project.

Scope project

Once a customer understands its requirements, it can then seek to scope out the project. At this stage, as well as seeking to define a process that will permit it to achieve its requirements and overall objectives, the customer must also consider how the proposed outsourcing might impact its wider business and what external factors might impact the outsourcing process.

Typical scoping exercises would cover:

• commercial issues such as the financial cost of the outsourcing, risk management and supplier incentives
• technical considerations such as what the customer wants from the deal at a practical level and how it will measure this, the supplier's ability to deliver it, what skills the customer needs to manage the deal, and what the service levels might look like
• the regulatory impact of the deal on the customer's regulatory compliance
• employment law and HR considerations, which would cover compliance points relating to the Transfer of Undertakings (Protection of Employment) Regulations 2006, SI 2006/246 (TUPE Regs 2006), plus managing affected employees’ needs and expectations.
• privacy and data protection law
• deal structure

Commercial considerations

Key commercial matters to be considered include:

• identifying the commercial risks that need to be managed (such as the impact on users of the service, stakeholders and customer service if things go wrong)
• an assessment of how any chosen supplier might be incentivised to ensure such risks are managed (e.g. liquidated damages, step-in rights, service credits regime etc, but also bonus or 'gainshare' arrangements)
• establishing the current costs of utilising the service in its current form and the likely future costs so as to establish a baseline for any charging mechanism to be agreed with a supplier, and
• an assessment of what contractual tools (be it service credits or contractual rights to terminate or step in to service provision) might be required to ensure that the technical requirements are met; these are often described as incentives but as often as not they are disincentives or deterrents

Technical considerations

This is often the main focus of the scoping phase. However, while the technical issues cannot be overemphasized, they are only part of the scope of any project. Key issues include:

• analysing the technical constraints on the project, particularly in relation to how the supplier will work with the customer's retained organisation and other service providers, and how transition of the services to the supplier would be managed
• assessing what skills the customer needs to retain in order to manage the receipt of the services, i.e. what the customer's retained organisation will need comprise (this retained organisation would typically report to the key customer stakeholders and be their 'eyes and ears' when it comes to managing the relationship)
• assessing what technical constraints the customer's existing infrastructure, processes or other inputs into the outsourced service will place on the ability of the supplier to achieve the desired outcome
• considering how to translate the higher-level outputs of the preceding requirements analysis phase and customer’s objectives into a technical requirements specification
• considering what third party agreements (such as software escrow or software licensing agreements) might be required to support the project, and
• considering how to define the service levels that will identify if the services are being performed at the required level

Regulatory impact

The customer must assess what regulatory impact the deal may have. This will vary from project to project (depending on the industry sector it is in).

For example, in the financial services sector outsourcing deals are subject to specific rules and requirements.

Deal structure

Typically, outsourcing deals are structured as a contract between a customer and a supplier with the supplier agreeing to manage the process of transferring existing services across (which may be accompanied by the transfer of people, assets, contracts etc.), and then delivering those services to the customer. However, a variety of deal structures are available both within the traditional customer/supplier model (e.g. if the customer wanted a dedicated service or would be happy to take advantage of a shared service centre) and beyond (by considering alternative deal structures).

One such alternative model is multi-sourcing, where the customer enters into a number of contracts with different vendors who then must work together to deliver the customer's desired outcome. The risks with this model are that no one supplier takes responsibility for delivery, and that the customer must have a sophisticated (and potentially expensive) contract and delivery management organisation. However, a well-managed multi-sourcing environment can encourage competition and innovation by rival suppliers, drive costs down and increase flexibility. The customer can also choose specifically which vendor to use and has full visibility of their offering.

Another alternative structure is for the customer and the supplier to set up a joint venture (JV) company that sub-contracts service provision to the supplier but that can give the customer ownership (or partial ownership) by keeping the customer's employees within the customer's group. The JV approach to outsourcing has largely fallen out of favour but continues to be considered, particularly for large public sector projects where the customer (in this case a public body) wants to ensure that, if the contract becomes very profitable, the taxpayer has some of that benefit returned to it.

Most outsourcing projects involve an element of subcontracting by the supplier but some deals are far more structured with the supplier being obliged to put together a formal consortium of (usually specialist) sub-contractors and to bid as prime contractor. This combines elements of the multi-sourcing approach (ie the ability for the customer to dictate who is used and to see more clearly the deal structure and service costs) with the traditional one supplier to manage delivery.

Each structure will have tax implications associated with it that need to be fully considered and factored into each party's financial modelling in deciding which type of arrangement will deliver the optimum benefit.

Offshore/near shore and cloud services

Finally, no scoping exercise would be complete without considering each of the above issues in the context of whether or not it would be appropriate for the customer to take advantage of the likely cost benefits of moving to an offshore environment or to a cloud environment (which could involve a mixture of offshore and onshore services). In this context, near shore (i.e. moving to eastern Europe if the customer is western Europe-based or, say, Mexico, if the customer is US-based) might also be considered.

Procurement process

?Having worked through its requirements and scoped out the project, any prospective outsourcing customer then needs to undertake the formal process of procuring a deal.

By this time the customer should have its deal team together and have gathered a large amount of information. This team should then work with this information to:

• draft a request for proposal (RFP)—sometimes, customers decide to test the market and then draft their RFP to reflect what the market can provide. In such cases, a two-stage approach is adopted where the customer drafts a request for information (RFI), issues and then considers the responses before drafting and issuing its RFP
• draft terms and conditions and schedules (though many schedules describing the detailed pricing, service description, and service levels will be created based on RFP responses). Sometimes, customers decide to issue shorter key contract terms or contract principles with the RFP, and then draft full terms and conditions later on. This can save some time and costs at the RFP stage but if left too late in the procurement process (ie until after down selection) can result in the customer losing the benefit of the element of competition between bidders, and
• decide on its approach to bidder due diligence and negotiation, eg whether the team will keep two or three bidders involved throughout the process or aim to down select one vendor sooner rather than later, and whether there may be some negotiation and/or revision of customer requirements following which bidders will be asked to submit ‘best and final offers’.

In this context, note that sometimes the whole procurement process is circumvented with the customer simply going to a preferred supplier and doing a deal or even a supplier putting a case to the customer and agreeing a deal. Both of these approaches have benefits in terms of time and reducing transaction costs but equally, by removing the element of a market testing and competition, they can expose the customer to doing a bad deal.

At this point, the RFP and draft agreement (and/or key contract terms or contract principles if the customer decides to take this approach) should be issued to the market and responses sought. Often, it is wise to meet with key potential bidders beforehand to introduce them to the project and ensure they are ready to respond once the RFP is issued. Also, as noted above, some customers may undertake a two-stage process of issuing an RFI before then issuing the RFP and agreement to a more limited set of bidders.

Part of this process, of course, involves signing prospective suppliers up to non-disclosure agreements. Care should be taken to allow the customer to use insights gained from discussions with suppliers (though not commercially sensitive pricing information) to better structure the eventual deal, even if that deal is with a different supplier from that with which a given discussion started.

As the customer prepares to go public it should consider if it needs to notify its staff, customers or regulators and ensure that if it is required to do so (for example, under certain employment law regimes or for public sector projects), it does so in a compliant, timely and well-ordered manner.

Selection and contract

Once responses to the RFP have been received, the customer must:

• review the responses and carry out due diligence on the bidders
• choose the preferred bidder(s), which will usually include scoring bidder responses based on pre-set criteria that are set out in the RFP as a way to objectively compare bids
• engage in negotiations with the preferred bidder(s)
• permit the bidder(s) to carry out due diligence on the customer's existing service provision (though it is worth noting that some customers take the view that the bidders are experts and should know what they are getting into without due diligence). This latter approach poses risks to the health of the longer-term customer/supplier relationship but can be necessary if time is tight or the customer only has limited diligence information to provide
• depending on the approach taken to the terms and conditions and schedules at the RFP stage, draft and/or finalise the commercial, technical and other schedules, and the terms and conditions, and
• finalise the commercial and legal deal

As regards due diligence, if the customer takes the tough line described above, it faces real risks. Some high-quality suppliers may decline to bid, while others may increase their price or seek to impose a wider variety of assumptions, and warranties and responsibilities on the customer, to try to address the increased risk.

As can be seen from the diagram above, the actual agreement only comes in to play part way through the outsourcing lifecycle but, once signed, it is immediately under scrutiny. The cliché that 'the only certainty is change' certainly applies in an outsourcing context, so the outsourcing agreement must address the issue of governance and change of control, and the parties must be aware that signing the outsourcing agreement will not end all negotiations for the entire team but rather provide a structure for ongoing discussions.

It is crucial that the outsourcing agreement sets out:

• the core of the deal (ie price, scope and service levels)
• how delivery will be managed (including the transition into steady state service provision)
• what metrics will be used to measure delivery
• what will happen if services are delivered poorly
• how the process of re-tendering will be managed
• how the exit process (if a re-tendering results in change of supplier or an in-sourcing) will be managed

Any contract would, of course, also have to cover the usual legal matters such as warranties, indemnities, liability caps, regulatory concerns and the approach to dealing with intellectual property rights.

Finally, in the case of public sector procurements, the customer must continue to have regard to any rules applicable to the procurement throughout the selection and contracting stages.

Delivery and contract management?

Delivery and contract management is the most important part of the outsourcing lifecycle. In many ways delivery is a lifecycle within the wider lifecycle. If the processes undertaken in the lead-up to service delivery have been undertaken thoroughly and professionally, there ought to be few surprises and problems and if they do arise, they ought to be more manageable.

Key aspects of delivery and contract management include:

• transition management—ie managing the process by which the service and any relevant people, assets and contracts are transferred to the supplier
• governance—ie the process by which the relationship between customer and supplier is managed and recorded
• reporting—i.e. the process by which the supplier keeps the customer up to date on its own performance and other matters the customer has identified as being crucial to its oversight of the relationship and/or service delivery
• change control—ie the process by which the inevitable changes that will occur during the term of the outsourcing agreement are managed and, crucially, recorded. A badly run change process can destroy the economics of a deal and the relationship between the parties
• price protection—ie how issues such as inflation (or cost of living adjustments or COLA), foreign exchange rates and investment in new equipment are managed
• assumption management—i.e. what happens if the assumptions underpinning the deal change. Most agreements build in some flexibility around pricing to reflect changes in usage and major changes will probably require renegotiation but there should ideally be some tools to allow flexing up or down within managed pricing boundaries
• transformation management—i.e. if the deal envisages that the service will be transformed, a process to monitor and record this transformation must be included
• performance management—i.e. monitoring service quality and invoking contractual protections such as service credits, step-in or even termination, if things go wrong
• market testing and benchmarking. Always a contentious issue, but in a long-term deal the customer may want the right to test that the service it receives and price it pays are in line with market norms, and
• exit management—i.e. managing the process by which the service and any relevant people, assets and contracts are transferred to a new supplier or back to the customer

Contract end/renewal

As the end of the term approaches (be it due to the expiry of the term or a decision to terminate early), the lifecycle comes full circle and customers should start the outsourcing process again.

Typically, the requirements analysis process will start 12–18 months before the expiry of the existing outsourcing agreement so that a new supplier or, if the service is to be in-sourced, the customer are ready to take over service provision at the end of the existing outsourcing agreement. Sometimes a decision may be made to renew or extend the existing outsourcing agreement for a limited period to permit more time for the analysis, scoping, procurement, selection, and contracting phases to take place.

In the lead-up to the end of the term, the customer should:

• obtain information on the existing state of the services, including how many staff are involved, what equipment is involved and what the actual levels of service performance are
• consider the value obtained from and the price paid for the current services, and how it may wish to change things in future, and
• ensure it invokes the exit procedures (including complying with any termination or renewal notice periods) in a timely manner

Andros Consulting Limited

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