Strategic CIO // IT Strategy
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5/16/2013
11:56 AM
Kate Vitasek
Kate Vitasek
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Vested IT Outsourcing Deals Avert A Catch-22

Customers and suppliers say they value innovation, but most outsourcing relationships end up becoming a race to the bottom. In "vested" outsourcing deals, both parties are vested in each other's success.

A Catch-22, taken from the classic Joseph Heller novel, is a no-win situation that uses contradictory, circular logic. For instance, you need a pass to enter a particular building, but in order to get a pass you must visit an office in the same building.

There's something of a tangled Catch-22 in the IT outsourcing industry. It comes into play when service providers meet contractual obligations but are limited in their ability to invest in the kinds of innovations that would make their customers loyal long term. They're afraid those customers will take their ideas and bid out the work to others, so the customers end up looking elsewhere.

A conventional, transaction-based business model and old-school procurement practices are the heart of the problem. To get a clearer picture, it's important to understand the behaviors created with the transaction-based model.

Service providers are in a virtual activity trap: the more activities, the more revenue; the more revenue, the more profit. They may want to "add value," but only if it comes with billable activities or resources with hefty profit margins. Of course, this makes sense. What supplier doesn't want to get paid for the work it does?

But the customer side also has flaws. Many -- too many -- IT executives say they want a "strategic" partner. So while their hearts and minds are going in one direction, their pocketbook and procurement organizations create a countermovement. Old-school procurement processes emphasize "leverage" and commoditization to ensure that the buyer gets the best price for each transaction. Value? Isn't that something the supplier tosses in for free?

[ Is the U.S. talent pool really as dangerously shallow as some want you to believe? IT Talent Shortage Or Purple Squirrel Hunt? ]

Initial outsourcing deals were disruptive: By using labor arbitrage, customers extracted big initial price savings that let them reduce costs and let their suppliers earn hefty profit margins. But the labor arbitrage game is coming to an end.

The result is a real Catch-22. Buyers and sellers want innovation, but neither wants to make the investment. So now what?

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A Hybrid Approach

Oliver Williamson, the 2009 Nobel laureate in economics, has spent his life studying a concept called transaction cost economics. Williamson argues that buyers and suppliers should develop a "hybrid" approach for dealing with complex contracting and business relationships. Under such an approach, companies treat suppliers as very strategic, almost as an extension of the company. Hybrid models are well suited in instances where there's a high level of dependency -- where it's hard to switch suppliers, for instance, or an insourced alternative may not be a good fit.

A research team at the University of Tennessee has been studying these types of highly collaborative relationships for 10 years and has codified a methodology for structuring "vested" outsourcing deals, whereby both parties are vested in each other's success.

Vested deals follow five key rules:

--They focus on outcomes, not transactions.

--They focus on the what, not the how.

--They define clear and measurable outcomes.

--They move away from transactional prices (fixed fee or cost-plus) and instead use a pricing model with incentives to reward the supplier for achieving mutually defined outcomes.

--Their governance structure provides insight, not merely oversight.

It sounds pretty simple, but do such relationships really work? Look no further than Dell and GENCO ATC, the largest reverse-logistics provider in the U.S., which transformed a long-term, transaction-based outsourcing relationship into a vested partnership based on continuous innovation.

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