SOURCING RISK KEY PERFORMANCE

INDICATORS (KPIS)
WHAT IS SOURCING RISK?
The objective of outsourcing is to allow a company to focus on its core business by tasking an outside outsource
to handle its noncore operations. Outsourcing takes place when an organization transfers the ownership of a
business process to a supplier. The key to this definition is the aspect of transfer of control. This definition
differentiates outsourcing from business relationships in which the buyer retains control of the process or, in other
words, tells the supplier how to do the work. It is this transfer of ownership that defines outsourcing and often
makes it such a challenging process.

In outsourcing, the buyer does not instruct the supplier how to perform its task, but instead focuses on
communicating what results it wants to buy, leaving the process of accomplishing those results to the supplier. A
company may decide to outsource technology from a vendor for any of the following reasons:
• Lower cost
• Reliable delivery
• Process simplification
• Predictable cost and results
• Strong vendor reputation
• Inability to produce or procure the technology in-house

Outsourcing can often bring a company’s entire operation up to best-of-breed standards at a cost equal to or less
than current expenditures without huge capital expenses. In some situations, a company may outsource its entire
business operation, depending on the size of the company and its technological ability.

There are several items to consider before entering into any outsourcing agreement, including:

Readiness
Is the company ready to outsource? Many times, customers will start the outsourcing request for proposal (RFP)
and contract negotiation process before they have thoroughly evaluated the decision to outsource. This premature
action, often driven either by naiveté or executive-level mandate, that the outsourcing should be completed by a
fast-approaching deadline, can potentially cause many problems.

First, companies need to realize that the RFP, proposal and negotiation process is very time-consuming and
expensive for all parties involved, including the outsourcers. Consequently, before becoming involved in the RFP
process, qualified outsourcers want to confirm that the client has evaluated the outsourcing decision against other
available options and is serious about proceeding in good faith with the RFP process.

Second, many clients do not consider the intelligent negotiation of an outsourcing deal requires that they gather
and provide to the vendor extensive, validated internal data. Validation is important. Outsourcing negotiations may
experience difficulties at the “eleventh hour” when serious pricing and service-level questions arise because the
outsourcer has no confidence in the client-supplied data made available during negotiations and the due diligence
process. When internal data is not available or is of questionable validity, the outsourcer will not be willing to
commit and the customer will end up with a nonbinding “agree to agree” that buys the customer little.

This is not to say that the customer's internal IT or business operations must be perfectly aligned with leading
practices before they can start the outsourcing process; however, to have any realistic chance of structuring an
outsourcing deal that will last, the client must be prepared to build a foundation of reliable data on which
contractual commitments can be built. The challenges to accomplishing the outsourcing deal will be substantial
enough without undermining it with insufficient and questionable data.

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Time for the Process
Along with determining outsourcing readiness, customers should guard against trying to compress the RFP, due
diligence and contract negotiation periods unrealistically. Outsourcing deals are time-consuming. They are
complex and require a great deal of iterative discussion among the negotiation team members for the
outsourcers, customers and their professional representatives (e.g., consultants and lawyers) to agree upon and
document clear understandings. There is no cookie-cutter approach to outsourcing that will work in every
situation. The parties must take the time to get the fundamentals right and that includes adequate time for due
diligence, discussions and negotiations.

There is no rule of thumb for how long completion of an outsourcing deal should take after the RFP proposals are
received from outsourcers. Much will depend on how motivated and how well-prepared the customer is for the
process. One rule is clear, however, and that is that the process generally will take longer than the customer
estimates in the beginning, so the customer should build some cushion into the timeline for the deal. Invariably,
issues that no one anticipated will come up during the process and will require additional time for resolution. If an
arbitrary deadline is pressing, the temptation will be to postpone the issue to the post-contract period when
business disputes can be difficult to resolve.

The Deal That is “Too Good”

Many novices in outsourcing treat the process as though it is just commodity procurement. They look for the
absolute lowest price among competing bidders and then drive the price down to the floor, regardless of service
or maintenance levels. In outsourcing, this can be a big mistake. Quite often, certain outsourcers who are very
hungry for a deal will let them be bid down to less than justifiable profit margins just to sign the deal.

In these cases, the customer almost always ends up unhappy with the service levels and the outsourcer responds
that they are doing the best they can, given the low margins they are earning. In some cases, the margins may be
so low that the outsourcer approaches the customer with the suggestion that they want out of the long-term
contract unless the customer is willing to renegotiate.

In other words, it is not unheard of for outsourcers to overcommit to high service-level guarantees and bargain
pricing, whether knowingly or not. Prospective outsourcing customers have to be able to determine when they
have struck a properly balanced deal with the outsourcer.

A common complaint among outsourced customers is, “I can't get my outsourcer to respond or pay attention to
my problems.” Although we always hope for outsourcing relationships with outsourcers that work as close
business partnerships, it doesn't always work out that way. This is when a well-conceived outsourcing contract
could have made a difference.

Many components should go into the due diligence process and an outsourcing contract to ensure that the
customer gets the level of attention they deserve. For example, during the negotiation process, the customer
should determine whether the outsourcer's account manager assigned to the customer will have a proper level of
authority within the outsourcer's organization to deal effectively with the customer's problems.

Many outsourcers will agree to include contractual provisions mandating that the account manager will be
responsive to the customer. But customers often complain that although they may have a good relationship with
their account manager, the account manager doesn't have the clout necessary to get an appropriate level of
executive management attention within the outsourcer's organization.

Good service-level agreements (SLAs) with real bottom-line consequences attached are extremely important and
can make a big difference. An outsourcer that is not otherwise motivated often will begin to listen when
contractual service-level failures start impacting the outsourcer's profit margins. This is one reason to take the
time to prepare a proper and thorough SLA that includes remedies such as invoice credits and termination rights.
Other provisions, such as strong problem escalation procedures (to the highest management levels of the
outsourcer), can be equally effective.

Legal Counsel’s Effectiveness

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Lawyers representing customers in negotiating outsourcing deals find that the process is one in which the legal
and contractual issues blend with the business, technical and operational issues. Likewise, the customer's
negotiation team must address the many legal concepts in the context of negotiating their outsourcing deal. While
it is not the role of your legal counsel to provide consulting services, experienced outsourcing legal counsel have
seen over the years what works and what doesn't work in the structuring, selection and negotiation phases of
outsourcing. Your lawyer will be most effective when viewed as part of the overall outsourcing team and involved
in discussions and decisions in each phase. Do not assume that all the lawyer should do is review the contract at
the end of the negotiations.

Experienced outsourcing lawyers can be used effectively to bring focus and clarification to issues as they are
being negotiated. A common problem for customers who call on counsel late in the process is that they may have
agreed in principle to points without considering all the business and legal ramifications. Addressing these points
at the last minute can be difficult.

Use legal counsel effectively. An outsourcing lawyer can be most effective in guiding the client around common
pitfalls if the lawyer is brought into the deal early as an integral part of the RFP development, evaluation and
negotiation phases.

BUSINESS RISKS RELATED TO SOURCING

Failure to manage outsourcing risk can have the following impact:
• Reliance on third parties whose objectives run counter to the entity’s plans
• Reliance on third parties whose performance runs counter to the entity’s plans
• Reliance on startups or other vendors that may not be in existence by project completion
• Reliance on vendors with immature infrastructure may be unable to provide service, impacting its customers

Outsourcing is based on fundamental principles, that when applied at the outset, result in an effective, successful
relationship. The first of these basic principles is for the buyer to determine the scope of services and the metrics
(for the performance levels) it wants from the supplier. This is the only way a buyer can comfortably turn over its
process to the supplier and ensure value generation, which also ensures accountability from the supplier. It must
be done upfront before the contract is signed.

A sure cause of failure in an outsourcing relationship is for the buyer to let the supplier dictate services and
performance levels as well as an inadequate description of scope and boundaries for components of the service.
This can lead to a supplier providing something that was not agreed upon and then charging a premium for it, or
the supplier not providing something the buyer assumed it would be getting for the price it is paying. For example,
in an outsourced human resources (HR) function, the buyer must adequately describe the scope of services the
supplier is to provide (does it include payroll, administration of benefits, procurement of new benefits options,
recruiting, retirement benefits)?

Recently the pendulum of corporate identity has swung away from vertically integrated megacorporations to agile,
heavily outsourced entrepreneurial organizations. As with any business strategy, however, what works for one
company does not necessarily work for another. A decision to outsource more of a company's business
processes should reflect the long-term goals of the company, not the latest trends in the business community.

The general idea behind outsourcing is for a company to do what it does best and let the experts do the rest. Few
companies take this radical approach, choosing instead to outsource only the nonessential processes. Essential
noncore processes, then, stay in-house, unless outsourcing offers a strategic advantage. Generally, cost savings
alone is not reason enough to begin outsourcing a service. Sound reasons include one or more of the following:
• A change or expected change in market conditions increasing the need to concentrate management efforts
and resources on core competencies.
• A well-developed outsourcer market that offers advanced technology, specialized professional expertise,
significant capital investments, or innovative solutions and techniques that the company cannot match.
• The opportunity to shorten cycle times for such things as product development, production or customer
response.

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Lessons Learned

Develop an outsourcing strategy that reflects the corporate vision.

Deciding to outsource a process or service usually results in considerable change, employees will be affected,
overhead costs will change, management focus will shift, and cycle times will shrink. Without a cohesive strategy
that recognizes the potential for change, fragmented outsourcing activities can lead to problems that snowball into
customer dissatisfaction or business complications.

When developing a strategy, leading companies consider the company's sensitivity to risk. These risks may
include financial and strategic risks, such as diminished company image, loss of competitiveness, low morale, and
inability to attract and retain top talent. Several factors that can mitigate risk when outsourcing a given service or
activity include:
• Outsourcing the service is a common practice.
• The market is saturated with outsourcers.
• The service requires little proprietary knowledge or skill.
• The activity that drives the services is repetitive and can be easily automated.

Processes closely related to a company's primary products or services and that represent a competitive
advantage generally represent more risk. Developing a strategy with realistic financial goals is also crucial.
Outsourcing may reduce costs, but these savings are generally short term at best. The real financial advantages
lie with allowing management to focus time and resources on what the company does best and where it earns the
most money. The need to invest in new capital equipment is often a trigger to outsourcing consideration. A
company that needs new check printers, sorters and other equipment for accounts payable may choose to invest
the money in areas of the company that provide a return and begin outsourcing the payables function.

Keep in-house the processes that give the company a competitive advantage; outsource those
in which the company lacks expertise or efficiency.
Processes and services that do not make the company unique, and are not even necessary to the continued
success of the company, are nonessential. The company is less than competent in many of these areas. The first
and most obvious candidates for outsourcing are generally functions such as janitorial services, grounds
maintenance and employee food services. Most processes however constitute gray areas – essential but noncore
services such as web hosting, information technology management, web development and other business
services. They may be essential to running the company, but in themselves do not offer a competitive advantage.

For many companies, core competencies will be obvious. For others, positive identification of core competencies
may involve a close look at each function in the organization, as well as surveys and interviews with customers.
For companies struggling with an outsourcing decision, benchmarking can help identify those processes that
should be outsourced. Many companies have been surprised to find that they were not performing at world-class
levels or even mediocre levels.

On the other hand, a company may find that benchmarking shows that it can perform a noncore function better
and less expensively than an outsourcer can. Although some might argue that this makes the function a core
competency, regardless of how the function is categorized, it should remain in-house. This is because the benefits
of outsourcing probably will not outweigh the benefits of keeping the function in-house.

Work with trusted outsourcers, yet communicate expectations in an original contract.

The success of outsourcing depends a great deal on the outsourcer selection process. For some activities, one or
two people may be all it takes to select the outsourcer and transfer the process. This is typical of commodity
services with deep, highly experienced, outsourcer markets, such as photocopy services or garbage removal. For
other activities, people from several areas of the company may need to shape the overall expectations for an
outsourcer, identify the best outsourcer available and transfer the process to the outsourcer.

Best-practice companies put together an outsourcer selection team that includes representation by all potential
users. Members of this team will help write the RFP, review proposals from candidates and interview final

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candidates. The RFP should be thorough enough to allow all candidates to develop a realistic solution with
accurate prices. Withholding information needed to determine the level and scope of work will lead to outsourcer
failure, frustration and lack of incentives to perform.

Visits to the outsourcer's place of business help verify proposal information, confirm the outsourcer's ability to
handle the proposed volume of work, and provide a preliminary check on the outsourcer's capabilities needed to
perform as expected. In addition, reference checks can provide invaluable insights into an outsourcer's loyalty,
integrity and willingness to satisfy its customers or trading partners.

Many outsourcers will offer a standardized contract to expedite the approval process. Outsourcing contracts can
be full of loopholes and with a standardized outsourcer contract, the outsourcing company is more apt to be the
victim. Even a company that outsources several processes is not likely to have the same level of experience as
an outsourcer who "outsources" for a living. In addition, what may be ironclad in the contract for one service could
be a loophole for another. An experienced outsourcing lawyer can help not only with contract preparation, but also
with outsourcer negotiations, either at the bargaining table or from the sidelines.

Moreover, companies should create a replacement plan in the event they have to switch outsourcers. Most
companies do not have the expertise or staff needed to bring a process quickly and smoothly back in-house. A
well-thought-out transition plan can at least minimize the potential for costly delays and customer dissatisfaction.

Create an integrated team of company and outsourcer staff to manage the transition or startup
process and oversee ongoing performance.
Many companies fail in their attempts to outsource because they neglect the one group that has the greatest
power to make it successful – their employees. Transition planning should begin when the company first
considers outsourcing. Ideally, both the company and the outsourcer involve their HR experts early in this
planning process. The plan should describe the business process transfer activities; company and outsourcer
roles and responsibilities; and any changes in employee salary, wages and benefits.

Leading companies choose an outsourcer who is prepared to address HR issues before the contract is awarded.
A potential outsourcer who does not explore these issues early in the bidding process will not only fail to consider
cultural issues that will affect employee performance but also will fail to consider factors that could lead to costly
legal disputes.

Companies must minimize the impact that the outsourcing decision-making process has on employee productivity
and morale. The uncertainty that employees face during the transition process will directly affect work output.
Keeping the transition process short and communicating openly and often will help minimize doubts. The more
information a company can provide to its employees once they know their work will be outsourced, the less acute
their uncertainty will be. Companies should closely monitor the transition process, including progress, service
levels, employee morale and cost savings. The interfaces between internal processes and outsourced processes
should be monitored.

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Link outsourcer compensation to outsourcer performance.
The first step in tying outsourcer compensation to performance is to identify performance measures. The next
step involves collecting baseline measures before the outsourcer takes over.

Outsourcer performance requirements should specify 100% of the outcomes. If an outsourcer must meet 90% of
all service requests within three days, the other 10% may never be met. Holding the outsourcer fully accountable
would mean specifying performance levels for this 10%. In this case, full accountability might mean meeting 90%
of all service requests within three days and the balance within five days.

Other issues
Best-practice companies provide incentives that encourage peak performance from outsourcers as well as
including penalties for substandard performance. Cash penalties may fall short of compensating a company for
the full extent of its losses in the case of extreme nonperformance. Nevertheless, the benefit of including these in
the contract is that the risk of a cash penalty often helps the company get the full attention of the outsourcer's top
management when performance starts to slip.

The contract should distinguish between critical measures for which the outsourcer will be penalized if not met
and noncritical measures as well. For noncritical measures, the outsourcer may face significantly smaller
penalties, or the thresholds for nonperformance may be lower. In addition, financial measures should be adjusted
to inflation. Without this, faltering performance may appear to be consistent performance and average
performance may be superior performance.

QUESTIONS TO CONSIDER
• Are the core and noncore activities or functions clearly defined?
• Is there a full understanding of the total cost of activities outsourced or planned for outsourcing?
• Is there a competitive advantage for outsourcing?
• Has there been an exhaustive review of possible outsourcing vendors?
• Are the culture and values of the outsourced company understood and in alignment with the contracting
company?
• Are the company and its outsourcer operationally compatible (e.g., systems capabilities and reporting
standards)? Will they remain operationally compatible in their future strategies?
• Does the outsourcer’s pricing include incentive components? Are these incentives based on the achievement
of measurable, quantifiable goals that can be audited by outside parties?
• Is a competent internal resource available to manage the outsourcing arrangement? Is there an integrated
team of company and outsourcer staff to manage the transition of the outsource function?
• What management and monitoring tools can be used to effectively manage the outsourcing relationship?
• Is the outsourcer a viable organization, or have questions arisen about the outsourcer’s credibility?
• Is the service level defined contractually attainable by the outsourcer given their profit margin and resource
demands?
• What are the options if SLAs do not achieve management objectives?
• Have contingency plans been built?
• What are the skills transfer plans?

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