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Financial Accounting Outsourcing (FAO) Annual Report - January 2007

IT Outsourcing in the Small and Medium Businesses

Today's business world is chaotic. More companies are buying and selling divisions as they attempt to align the right set of values to plant a firm foundation in the market, and then bulldoze their competitors. Instead of developing a division in-house and waiting years for it to have a satisfactory client base, companies can purchase already-existing businesses complete with clients and a reputation. And information technology (IT) is playing a large role in these seemingly overnight transformations. IT changes daily and with it the business changes as well.

Many of these companies are also outsourcing their non-core functions. They use outsourcing as a tool, so they can spend their time on their strategic business goals instead of spending time updating their technology or running a mainframe. But what happens to the outsourcing contract when the business goals of a company change, or the output either increases or takes a dive? The contract must be flexible enough to change with it, says Dennis McGuire, president and CEO of Technology Partners International (TPI), a sourcing transaction consulting firm.

"No one can predict what's going to happen six months into the future, let alone two or three years," McGuire says. "So it's easy to see why flexibility is one of the things that a company spends the most time negotiating with the supplier."

Many companies with no experience in outsourcing think that having a flexible outsourcing contract is an oxymoron, but in reality the in-house solution is less flexible, he says. Most of a company's costs are fixed. So if a company sells a division and the IT utilization goes down 20 to 30 percent, the reality is that, because the company's costs are fixed, its costs don't go down that same 20 to 30 percent.

The Necessary Requirements

There are several ways that a company can assure a flexible outsourcing contract and continue to keep its initial integrity. McGuire says.

Non-punitive termination for convenience is one way to retain flexibility. And this termination can be done for either a whole service or for the entire contract. Usually after two years the customer can terminate the contract and pay a nonpunitive termination fee. "This is pretty important in case things don't work out with the supplier," McGuire says. "It gives our client good leverage in terms of negotiation."

There is also termination for cause, in the event that the supplier is not producing. "Depending on the actual reason for termination of cause you might give the supplier an opportunity to fix the problem. But usually termination for cause moves pretty fast," he says. "Usually the termination for convenience can't be invoked until after the second year. The reason for that is that it usually takes a year to settle things down and a year to see if the company really likes the service and how it's working."

There is also normal flexibility. The client and consultant do a multiyear projection and assume a certain number of billable resources per year. Then additional resource charges (ARCs) and reduced resource credits (RRCs) are negotiated. These charges are above and below the anticipated projection and are usually the same percentage for both. For example, if the percentage is 20 percent then the company's flexibility is 40 percent -- 20 percent up and 20 percent down.

Twenty percent is used in this scenario because usually, if an increase or decrease in billable resource usage of plus or minus 20 percent is attained, then a renegotiation is usually needed. McGuire says that this type of increase or decrease is usually caused by a significant event like buying a company or selling a division. The percentage used by the parties is negotiable, but a renegotiation level should be included in the contract.

ARCs and RRCs are intended for a situation when the client really can't plan, and are usually for short periods of time. "And in fairness to the supplier there needs to be a premium on this because it is not guaranteed. " he says.  "On the other hand, if the customer comes to the client and says they are going to have a guaranteed increase for a specific number of years, then the incremental cost should be significantly less.".

Amending the Contract

To realign the vendor and customer's direction, a significant contract amendment is suggested every two to three years. They shouldn't have to redo the contract, only change some specifics. McGuire says that if a company has a good relationship with its supplier and they have been working together for a year or two, the vendor and supplier ought to see other areas where there would be additional value by expanding the contract.

"Maybe there are some other services the supplier offers that the customer is interested in," McGuire says. "Maybe they can expand the contract to include some business process outsourcing instead of just IT outsourcing." Or the company could be growing geographically as well, he continues. As a company begins to extend its border outside of the United States some complexity is added and the contract will probably need to be amended at some point.

This reevaluation and subsequent contract amendment also keeps the integrity of the outsourcing contract in check. But the addition of service is dependent on the quality of the supplier's account management team and the quality of the customer's supplier management team. "If the two can't take a business view of the contract versus a real micromanagement view then there will be problems," he says. "If you can take a real business view I think there will be additional ways to leverage the contract and both sides can be a little happier."

McGuire says that if the two sides have good teams then the need for a consultant during the amendment phase is minimal. But on the other hand, if the company's team has been managing its own contract and no others, then they probably are not familiar with all the things that are going on in the marketplace, so a consultant that is involved in a lot of contracts can help.

"An amendment isn't really a huge effort and won't take too long," he adds. "But it is something that is fairly important."

Lessons From the Outsourcing Primer:

• Many companies are shifting their strategic position regularly, so it is important to have a flexible contract that changes with the business.
• Since in-house operations have fixed costs they are less flexible than an outsourcing arrangement.
• Non-punitive termination can be included in the contract so that the client can get out of the arrangement if it isn't what they expected.
• Termination for cause can be included in the contract in case the client isn't getting what it is paying for.
• Companies should do a significant amendment to the contract every two or three years in order to align both sides and to add new business.