Recession Takes A Bite Out Of Pay-For-Performance Outsourcing

Risk-reward IT outsourcing contracts, where service provider fees are tied to business outcomes, have been viewed as the next tier of maturity for the outsourcing industry. But the slowing economy has dampened interest in the model, and getting to that tier is going to take longer. That's not what we expected. Before the recession, interest had been growing among IT outsourcers and longtime customers in forging relationships where both parties share in benefits reaped through working together, but also share in any pitfalls. Outsourcers looked for "partnerships." To do this, they needed to shift to "higher-level" deals that didn't focus solely on cost cutting--including offshore labor arbitrage--but on strategic measures such as revenue growth and customer satisfaction. The reality is that such relationships are complex to set up, difficult to execute, and riskier, which means they require deep trust and a long-term view. All those obstacles become bigger in a downturn. Companies haven't given up the pursuit of innovation, and they're still working closely with their outsourcers, but they're paring down their project lists. And if there's a revenue-generating project to be done, CIOs are likely to want their own staff on it, rather than share the rewards with a services provider. "If you have 100 discussions with clients about risk-reward contracts, maybe only 10 will end up doing them," says Ray Strecker, head of Tata Consultancy Services' North America consulting practice. Eighteen months ago, two goals frequently came up during client discussions, Strecker says. One is still common: how to take direct costs out of the client's business, primarily with IT but sometimes through other operations, such as human resources. The second theme that almost always came up was how to shift the IT spending mix from running the business--support, security patching, data center operations--to fostering innovation. In those conversations, cost cutting was a way to "free up" funds for other purposes, Strecker says. In the last few months, however, the talk has shifted back almost solely to cost cutting as a way to "batten down the hatches," he says. Some clients continue to ask TCS where it can be a strategic partner in achieving objectives beyond cost cutting, such as improving customer service. Yet, even in the pockets of innovation where there is a shared incentive to improve performance, "we're not seeing revenue-sharing models," says Sultan Khan, head of TCS IT strategy and governance for North America, citing the complexity of such arrangements. Vincent Cirel, senior VP and CIO of Norwegian Cruise Line, says too many CIOs think of pay-for-performance narrowly--as the financial penalties outlined in service-level agreements, rather than incentives to perform better. SLAs aren't of much use to a CIO. If performance tanks to the point that it triggers an SLA, it will give the lawyers some work, but the CIO and business managers relying on it are out of luck. So when Norwegian Cruise Line inked a 5-1/2-year deal in October with IBM to run its reservations as an online service, Cirel included performance incentives (which he declines to detail). Follow The Money Between 15% and 30% of Computer Sciences Corp. contracts have risk-reward provisions. Like other outsourcers, CSC has seen engagements shift from supporting growth to "How can you help us become more efficient and save cash?" says Russ Owen, president of CSC's Americas commercial group. The risk-reward provisions often involve CSC getting a share of savings achieved on behalf of clients, such as helping insurers identify fraud or multiple billings for the same services. When CSC helps its outsourcing customers launch products, such as a new health insurance policy, it's often paid based on the volume of claims activity. CSC expects volume-based, variable payments, which usually involve business process as well as technology services, to be a growth business. Capgemini's risk-reward arrangements tend to have a business process outsourcing component as well. In one example, Capgemini has been working with an energy company that had been losing customers. It took over billing and customer service operations, and used analytics to spot the types of calls--like asking about rates--that are a red flag for customers who are at risk of leaving, then created offers to retain them. Capgemini earned a bonus based on the company's customer numbers. For a consumer-goods company, Capgemini is running a billing and financials system where incentives are tied to spotting double-billing and other problems. Capgemini has hired people with coding and audit experience to try to outperform the customer's accounting system, and Capgemini gets a cut of any recoveries that result. But it's a bonus, says David Poole, head of Americas business process outsourcing for Capgemini, not the main means of payment. Increasing revenue has been the goal of outsourcing efforts for a notable minority of companies--or at least it was before the worst of the downturn. In a survey by InformationWeek Analytics last spring of 272 companies, almost 30% cited increased revenue as a driver for BPO. In addition, 38% cited improved customer satisfaction and 42% faster time to market as BPO drivers. Not surprisingly, cost cutting was cited by 83% of companies. Even when the economy picks up, revenue- and profit-sharing deals will continue to be more the exception than the rule, predicts Dave Liederbach, general manager of global strategies outsourcing with IBM. The reason is that it's too hard for most companies to tie a service to driving revenue growth, and most outsourcers don't have the industry experience needed to set up such deals. "You have to have the capacity to track revenue and influence outcomes," Liederbach says. "If all you deliver is low-cost labor and insight into how your products work, ... you'll run into trouble in aspiring to higher-value outcomes." When IBM does tie contracts to outcomes such as revenue growth, Liederbach says, it's "not about extremes." Typically, only a fraction of the contract is variable. Also, in some industries, such as health care and government, revenue might be a less important measure than satisfaction or responsiveness. "Outcomes are based on client vernacular," he says. In working with Norwegian Cruise Line, an incentive for IBM is that it can leverage the reservation-as-a-service model with other customers in the travel industry, applying what it learns working with the cruise line. CIO Cirel says the model will help the industry overall without hurting Norwegian Cruise Line, since it's not the transaction that's the competitive differentiator, but the "shopping process prior to making a reservation" where IT can provide a company with competitive advantage. Liederbach points to Norwegian Cruise Line's move to reservations as a service as an example of companies cutting costs while using that as a reason to try new technology models. "While cost cutting is a part of what we're all doing, the best are cost cutting to be positioned for long-term growth," he says. EDS also is looking to cloud computing as a way to open up new pay-for-performance options. Today, most of its variable pricing contracts are output-based models, such as the volume of health care claims managed or e-mail boxes maintained. As more business processes can be moved online, they lend themselves to a variable model, says EDS VP Dan Zadorozny. However, don't expect big moves until the economy improves and business picks up. "We have some clients who are very interested in this when the time is right," Zadorozny says. Even with a better economy, any deal linked to revenue or profit should be treated with a rigor that's close to what a company would apply to a joint venture, from the financial accounting to how each puts in investment funds, says Kate Hanaghan, senior analyst at research firm Bathwick Group. Hanaghan estimates that fewer than 15% of outsourcing contracts today involve risk/reward provisions beyond conventional SLAs in which IT services providers are paid based on straightforward criteria such systems availability or cost-cutting measures. The more elaborate deals take more outsourcing management expertise than most companies have or are willing to develop. "Unless it's a mature buyer that knows the partner well, those kinds of deals are considered too risky, especially these days," Hanaghan says. "They require an enormous level of trust." Plus, as companies look down the road to what they hope is an upturn, they're loath to share in potential growth. "Most clients want to control their own destiny, rather than share it," says TCS's Khan. With a carefully crafted outsourcing deal, however, your company just might be able to accomplish both.