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The winner of an auction often falls victim to a malaise known as the winner's curse: overpaying for the item purchased. This can happen for many reasons. The purchaser either overestimated the value of the item, became involved in an emotional bidding war or simply was not well-informed.

This article examines how the winner's curse applies to the IT outsourcing (ITO) industry, why it is an issue for both the buyer (the company planning to outsource its IT function) and service provider, and what the buyer should do to avoid falling prey.

The Winner's Curse in Outsourcing

Outsourcing deals are often essentially the result of an auction, in which the prospective buyer of services writes an RFP (Request for Proposal) and then accepts sealed bids from a list of five or more prospective service providers. Based on price and other criteria, the buyer invites a short list of two or three service providers to an intense round of negotiations in which the buyer or the buyer's advisor seeks to extract the desired service levels at the lowest price.

At first glance, the four to eight percent margins in many areas of IT outsourcing, and the correspondingly low return on capital employed (ROCE) of most large service providers, would indicate that this process works to perfection -- for the buyer of services at least.

However, Credit Suisse First Boston firmly rebuffs this in its recent paper on EDS titled, "Is the IT Outsourcing Model Broken?" In brief, the writers believe that the "winner's curse continues to plague the industry." The company that "wins the business often does so because it bid irresponsibly for the contract," generally as a result of the competition and the resulting "irrational pricing." Although the research is focused on EDS and thus the service provider community, we agree with the central belief that "the concept of IT outsourcing is one that can and should make sense for both providers and customers."

Why must the relationship make sense for both parties in the transaction? Although the winner's curse generally can not rebound against the seller, who has long since transferred the 'as-is' sale item and received the agreed price, in IT outsourcing the company running the auction is actually the buyer who also will have to live with the result. Thus the winner's curse can also be the buyer's curse; not even the most ironclad contract is sufficient protection.

The rest of this article focuses on helping buyers avoid the winner's / buyer's curse. Although it contains many specific recommendations, there are two main points:

1. Choose your service provider based on a combination of price, quality and fit -- not price alone. Be skeptical of the cost forecast made by the service provider based on an RFP that may be incomplete and not reveal all the issues and opportunities present. Is it achievable and based on real leverage/expertise? It has been our experience that buying based on a very low forecast price without further investigation can be like a desert mirage in which the buyer never arrives at the illusionary oasis.
2. Build a sustainable deal. Outsourcing contracts are five-to-10 year deals. Thus, it is crucial to build a good deal that is sustainable over time in the face of changing market, technological and organizational issues. Transparency is key to reducing conflict, aligning interests and increasing flexibility. We have found that a lack of transparency is also a leading cause of the winner's curse (e.g., the service provider does not understand the complexities of the buyer's situation, while the buyer does not realize the source of cost savings and/or the services not included in the proposal).

The logical first step in building a long-term relationship is to determine which service provider has the leverage to provide efficient service while also meeting the other goals for the outsourcing relationship. By focusing on the varying strengths that service providers can bring to the table, a buyer and service provider can work together to shape a solution that is both low cost and tailored to meet other aims.

Choosing the Right Service Provider

The key to selecting the right service provider is to put in place a process that stresses collaboration as well as early and frequent service provider interaction to best leverage its uniqueness/expertise, and joint solution/specification development. This implies first setting clear goals and then evaluating each potential service provider's ability to achieve those aims. Different types of deals need different types of leverage. For instance, economies of scale and labor arbitrage might be most important in realizing cost savings, while industry knowledge and process expertise might be the deciding factors if the goal is improved business operations. More specific recommendations include:

1. Evaluate service providers based on their potential leverage points, as that has the best predictive value of the service provider's ability to deliver efficient service and other desired benefits.
2. Work with the service providers to translate their particular capabilities into potential solution options for you. This can result in solutions that are more innovative and cheaper than responses obtained purely through an RFP process, as it frees service providers to propose options such as offshore transaction engines.
3. Get specific commitments that are measurable.
4. Involve the service providers early in the process so that they have a chance to help shape the solution rather than just responding to the RFP. Early RFPs reduce the likelihood of a creative, high-value solution.
5. When possible, price the deal based on business results, not a per-unit commodity price.

Building a Sustainable Deal

We believe several factors (e.g., the poor economy and the accompanying pressure on sales executives within the service provider community) have moved the industry toward a commodity approach with sometimes too aggressive, unrealistic pricing. When this happens, the service provider may begin to nickel and dime the buyer. Poor relations and a lack of innovation result. To build a long-term, sustainable relationship, buyers need the following:

• Alignment of interests. While contracts are essential, they are not sufficient. Win/win relationships allow the customer and service provider to work together to improve the services provided to the benefit of each. Put financial incentives in place to penalize poor performance or reward better-than-expected results.
• Transparency. Outsourcing relationships are by nature complex. Additionally, due to the length of most contracts, they must be flexible. Transparency can reduce the risks for both sides and provide a basis for adding/changing services over time.
• Strong governance. There are two often neglected aspects of governance. The first is disciplined adherence to the model. Buyers must measure metrics, close any performance gaps, and have executives oversee the relationship. The second is thoughtful application of new technologies and process improvements to create additional value.
• Understanding of the sources of leverage. When the buyer and service provider jointly shape a solution based on goals and strengths, they concurrently set expectations for their relationship and a high level plan for fulfilling those objectives. This reduces the surprises during the transition period and greatly increases the likelihood of long-term success.

Focusing on a long-term win/win relationship can ensure that buyers actually capture the benefits they expect at contract signing and also realize further value over time.

In Summary

Avoiding the winner's curse should not mean succumbing to an empty sales pitch or sugar coating negotiations. Instead, we advise buyers to be aware of the complex, long-term nature of outsourcing relationships and the limitations of any contract. Choose your servic provider based on its leverage points and then build a relationship that maximizes the value captured from those new capabilities.

Lessons from the Outsourcing Journal:

• The winner's curse can negatively affect both the buyer and servic provider of outsourced services, unlike most auction situations.
• Choose a service provider based on evaluation of its unique capabilities in light of the objectives of outsourcing the function.
• Outsourced services are complex and long term, and it is difficult to protect fully against scope expansion. Build a sustainable relationship by focusing on transparency, alignment of interests, strong governance, and an understanding of the servic provider's sources of leverage.

Publish Date: November 2002

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Copyright © 2002 - Everest Partners, L.P.

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