It’s long past time for a change in the way outsourcing contracts are negotiated and managed. In 1968 the legal scholar Ian R. Macneil observed that most contracts are ill-equipped to address the reality of business needs. In Contracts: Instruments for Social Cooperation, Macneil wrote, “Somewhere along the line of increasing duration and complexity [the contract] escapes the traditional legal model.” He argued that contracts are rooted in the classical approach to contract law, and thus crafted to address transactions and legal protections such as pricing and price changes, service levels, limitation of liability, indemnification and liquidated damages.
Those classical approaches to contract law are still mostly with us. An April 2010 study by the International Association for Contract & Commercial Management (IACCM) concluded that contract terms remain mired in the classical legal approach of contract law, which focuses almost exclusively and hierarchically on pricing, limiting liability, indemnification, service and transaction levels, risk mitigation and liquidated damages.
For example, a common mistake companies make in outsourcing today is that they create detailed statements of work (SOWs) and then try to define too tightly the work to be done. They handcuff their service providers’ innovation and flexibility in this way.
A flexible approach and a flexible agreement framework is needed, one that the Nobel laureate Oliver E. Williamson suggests is highly adjustable or adaptable, rather than one that prescriptively outlines detailed transactions, rigid terms and conditions, SOWs and working relations. This is because business happens constantly and unpredictably.
University of Tennessee researchers set out to find a better way to develop outsource agreements and their research led them to study some of the most successful outsourcing agreements, such as Microsoft’s back office procure-to-pay contract with Accenture that has won awards from SSON, IAOP, and the Outsourcing Center. Their research led to the discovery that successful agreements operated differently – one moved away from traditional buy-sell arms’-length contracts. Researchers coined the approach these successful deals uses as “Vested Outsourcing” because buyers and sellers created contracts that were steeped in mutual advantage – binding each party to a win-win approach.
Vested Outsourcing’s approach requires the parties to build a solid, cooperative foundation for sharing value – together. Highly integrated outcome-based business models use value incentives to maintain mutual advantage.
The Ten Elements of a Vested Outsourcing Agreement
But what exactly goes into a successful Vested Outsourcing business agreement? University of Tennessee’s Center for Executive Education has teamed with the International Association for Contract and Commercial Management to develop The Vested Outsourcing Manual – a step-by-step guide for developing collaborative business-to-business agreements and working rules that will facilitate successful and long-lasting business relationships based on mutually Desired Outcomes. The Vested Outsourcing Manual builds on pioneering work done by the University of Tennessee, and outlines ten elements that should be included when developing an outsource contract. Think of the elements as signposts directing you along the right road to the desired destination: a successful, long-term Vested relationship.
The Ten Elements are keyed to implementing Vested Outsourcing “Five Rules”, as outlined here.
1 Focus on Outcomes, Not Transactions
Element 1: Business Model Map
This first step is to understand and document an outsourcing business model. It is vital to take the time and map potential outcomes and to see how well the parties are aligned to each other’s goals. Jointly mapping a model will pinpoint the transactions of value between the parties, leading logically to collaboration, loyalty and mutual satisfaction, market share and sustainable profit. Use the model jointly to compare results. Element 1 also fashions a culture in which the company and the service provider maximise profits by working together more efficiently, no matter who is doing the activity.
Element 2: Shared Vision and Statement of Intent
With the business model understood and mapped, the parties then work together on a joint vision that will guide them for the duration of their Vested relationship. A cooperative and collaborative mindset opens a conversation between the parties: the result is that they share what is needed, admit to gaps in capability, and aim to focus on the benefits that the other party can bring to enhance any gaps in capability. That vision and alignment forms the basis of a Statement of Intent drafted by the outsourcing teams.
2 Focus on the What, Not the How
Element 3: Statement of Objectives/Workload Allocation
This element lays the foundation for the parties in the Vested partnership to do what they do best. Depending on the scope of the partnership, the company transfers some or all of the activities needed to accomplish agreement goals to the service provider. Together they develop a Statement of Objectives (SOO), which is very different from a standard SOW. Simply put, a SOO describes intended results, not tasks. Based on the SOO, a service provider will draft a performance work statement that defines in more detail the work to be performed and the results expected from that work.
3 Clearly Defined and Measurable Outcomes
Element 4: Top-Level Desired Outcomes
To have an effective, successful Vested Outsourcing relationship, the parties must work together to define and quantify Desired Outcomes. This element is a centrepiece of the whole enterprise because without mutually defined Desired Outcomes in place, a Vested agreement cannot go forward. Outcomes are expressed in terms of a limited set of high-level metrics. It is imperative that the parties spend time – jointly and collaboratively – during the outsourcing transition and particularly during agreement negotiations to define exactly how relationship success is measured. Once the Desired Outcomes are agreed upon and defined, the service provider proposes a solution that will deliver the required level of performance at a predetermined price.
Element 5: Performance Management
Once Desired Outcomes, Statements of Intent and SOOs are in place and the agreement is implemented, the parties then measure performance to determine if the Desired Outcomes are achieved. These include high-level performance management measures that are easily understood by business stakeholders and all parties involved in the process. The metrics will help align performance to strategy.
4 Pricing Model Incentives that Optimise Cost/Service Trade-offs
Element 6: Pricing Model and Incentives
In order to attain Desired Outcomes, the parties must have a properly structured pricing model that incorporates incentives for the best cost and service trade-off. The approach of many procurement professionals to outsourcing is stuck on one thing: getting the lowest possible service and labour pricing. The strategic bet – and paradigm shift – of Vested Outsourcing is that the service provider’s profitability is directly tied to meeting the mutually agreed Desired Outcomes. Inherent in this model is a reward for service providers to invest in process, service or associated product that will generate returns in excess of agreement requirements. Higher profits are not guaranteed – what business model can claim that? – but this element provides service providers with the authority and autonomy to make strategic investments in processes and product reliability that can generate more value and a greater return on investment than a conventional cost-plus or fixed-price-per-transaction agreement might yield.
Incentives are a key component of this mix, because service providers are taking on risk to generate larger returns on investment. An incentives package delivers the most commercially efficient method of maintaining equitable margins for all parties for the duration of the relationship. Pricing models using margin matching are recommended for use in the Vested agreement. Margin matching is used to adjust pricing points by establishing trigger points that reset prices when that point is met. For example, the inflation rate might be a trigger point for resetting inventory carrying cost charges.
5 Insight versus Oversight Governance Structure
Element 7: Relationship Management
A relationship management structure creates joint policies that emphasise the importance of building collaborative working relationships, attitudes and behaviours. The four elements associated with Rule 5 provide the tools for parties to manage and operate the Vested agreement. The parties monitor the agreement within the framework of a flexible governance structure that provides top-to-bottom insights into what is happening. The Vested agreement is not based on transaction counting!
Element 8: Transformation Management
This is a new relationship model – people and company ecosystems are changing; the parties are doing things differently and probably not operating in familiar comfort zones. Managing this transformation, including transitioning from old to new – along with change management once the new agreement is up and running – is often difficult and complex to implement. It is imperative to preserve as much continuity as possible among personnel and teams as the transition progresses into day-to-day implementation and operation. The focus here is on end-to-end business metrics, mutual accountability for Desired Outcomes and the creation of a culture that rewards innovation, agility and continuous improvement.
Element 9: Exit Management
Sometimes the best plan simply does not work out or is trumped by unexpected events. Business happens, and companies should have a plan when assumptions change. An exit management strategy can provide a template to handle future unknowns. The goal is to establish a fair plan and to keep the parties whole in the event of a separation when the separation is not a result of poor performance.
Element 10: Special Concerns and External Regulations
Governance frameworks are not one-size-fits-all, especially in more technical or complex relationships. The final element recognises that all agreements are different and that many companies and service providers must understand and adhere to special requirements and regulatory protocols. Thus, a governance framework may need to include additional provisions that address specific market, local, regional and national requirements. For instance, in supplier and supply chain relationships involving information technology and intellectual property, security concerns may necessitate special governance provisions outside of the normal manufacturer-supplier relationship. Supply chain finance and transportation management are other areas that often require special handling under the governance framework.
Developing a business agreement using Vested Outsourcing’s Five Rules and their Ten Elements is much more than delivering a higher level of service on a given activity, a blur of metrics or simply counting transactions or filling seats more cheaply.
Completing the Ten Elements will enable progressive companies to change their mindset and challenge old-school approaches by establishing a dynamic, modern business-to-business agreement.
By developing outsource agreements that include the Ten Elements, firms learn by doing and transition their thinking from the adversarial to the truly collaborative. They move beyond simply paying lip-service about “collaboration” and “partnership” to actually creating a win-win agreement and an atmosphere that drives transformative change.