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Winning Strategies for Outsourcing Contracts

March 1, 1994
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Two years ago, Los Angeles-based First Interstate Bancorp. outsourced its entire benefits function to Towers Perrin, a management-consulting firm. It wasn't the first time the bank had used outside vendors to perform traditional human resources functions. It previously had outsourced its relocation functions to Paragon Decision Resources, Inc. in Illinois and temporary employment services to Talent Tree Personnel Services in California. In all cases, the lesson was clear: Outsourcing is not just a matter of farming out services for expediency. On the contrary, it is the meticulous pursuit of long-term "strategic partners."

Learning to establish the right relationship is increasingly important because continued outsourcing looms on the horizon. If current trends continue, typical large corporations of the future may consist of a relatively small core of permanent employees, with the remainder of the work force composed of individuals who are hired for specific, temporary assignments, and a network of vendors. Indeed, a recent 927-company survey conducted by Washington, D.C.-based The Wyatt Company, shows that 32% of employers already outsource some or all of the administration of their human resources and benefit programs. In this environment, the vendor becomes an extension of the company, and the relationship rises above the traditionally narrow buy-sell level. "We're dealing with a very professional, desired relationship," says June Jones, senior vice president of corporate employee relations at First Interstate. "We have looked for people who could really add value to the corporate mission and strategies."

Once a company decides to outsource, however, the contract is the primary mechanism to ensure that both its expectations and the vendor's are realized. Negotiating a successful contract for both parties often can be an arduous process. Unlike one-time vendor contracts, outsourcing contracts require a different mindset because outsourcing vendors actually are integrated into the company over a long-term period during which they become privy to inside information. That's why it takes months to select the proper vendor. And the key, according to those who have benefited from such relationships, is for a company to know its needs and goals before starting the selection process. In addition to specifying the scope of desired services and nitty-gritty working arrangements, outsourcing contracts can also include protection clauses for arbitration, confidentiality, risk sharing and penalties.

Whether the function being outsourced is part of personnel or from another area of the company, such a relationship involves a multitude of HR issues. Human resources specialists, therefore, need to be involved early on in the process, starting when the company begins to conduct its needs assessment, establish its short-and long-term goals, determine its decision-making structure and project the estimated costs.

In fact, HR departments already play a role in some 65% of all company outsourcing cases, up from about 35% in the past. So while the search and selection team ideally involves a top executive, the respective department manager and a legal expert, human resources often plays a critical role as facilitators and coordinators of the entire process.

It's a natural role for human resources professionals to play because of their communication and administration expertise. They are qualified to assist in the proper selection and management of outside vendors. They can maintain focus on the company's growth strategy, its corporate environment, workforce culture and overall objectives. "HR knows best the company's personnel requirements and is skilled in asking the right questions in order to obtain quality staffing," says Kathleen Correia, president of Accounting Solutions, a national consulting firm supplying organizations with professionals in accounting, human resources, management information, financial analysis and computer systems.

As a trend sweeping U.S. companies of all sizes, outsourcing is the purchase of a good or service that previously was provided in-house. Information-systems outsourcing options, for example, have existed since the beginning of data processing. As early as 1963, Electronic Data Systems (EDS) handled data-processing services for Frito-Lay and Blue Cross & Blue Shield. Today, other outsourcing options include such functions as mail room, data processing, COBRA administration, payroll, temporary employment services and relocation.

But not all experts agree that outsourcing is a friendly partnership. In a study of 14 Fortune 500 companies that faced outsourcing decisions, the companies most dissatisfied with outsourcing all had signed contracts that dramatically favored the vendor. The contracts merely stipulated that the vendor would provide the same level of service that the company received prior to outsourcing.

The study was conducted by Mary C. Lacity, assistant professor of management information systems, College of Business Administration, University of Missouri, and Rudy Hirschheim, professor and director of the Information Systems Research Center, College of Business Administration, University of Houston. (Their detailed case studies appear in their book, "Information Systems Outsourcing: Myths, Metaphors, and Realities.") Although these researchers focused on information-systems outsourcing, many of the lessons included can be applied to how human resources departments work with any vendor that is providing an ongoing service or function.

Lacity and Hirschheim warn that viewing outsourcing vendors as "strategic partners" can be a mistake because the profit motive is not shared. Account managers at outsourcing providers, they say, are rewarded for maximizing profits, primarily by charging customers additional fees for services that extend beyond the contract. When a customer's costs increase, so do the vendor's profits.

The danger in viewing the vendor as a strategic partner, they emphasize, is that the customer may sign a loose contract. Once it goes into effect, the vendor may not provide the expected service. One petroleum company that outsourced its entire information systems function in the late 1980s, for example, was charged $500,000 in excess fees the first month into the contract. That was 50% more than what it had expected, because the company managers assumed the services already were covered in the contract. But the vendor rightfully claimed that services not documented in the contract are above baseline and so are subject to additional fees, according to the study. This doesn't mean that vendors are inherently opportunistic. What's more likely is that both parties failed to communicate clearly from the beginning.

Despite the risks, however, more and more companies view their outsourcing vendors as strategic partners. The most important tips for negotiating an outsourcing contract—once your needs have been assessed—focus on ensuring that the relationship will work given the customer's real needs, while allowing for future changes:

  • Institute a detailed Request for Proposal (RFP) process
  • Solicit possible vendor references
  • Discard the outsourcing vendor's standard contract
  • Don't sign incomplete contracts
  • Select your account manager
  • Measure everything during the baseline period
  • Determine growth rates
  • Take care of your people.

Activate an aggressive bidding process.
When First Interstate initiated its outsourcing search, the company began with a mission statement of values and strategies. After promoting it within the organization, the statement was communicated during the RFP stage. As potential vendors were interviewed, they were introduced to First Interstate's background: who they are, how they're configured and some of their communication challenges and needs.

For example, when First Interstate outsourced its employee relocation services, one aspect was contracting van-line businesses.

What they found was that many van lines operate very independently. So the company asked the van lines to give one proposal through their franchise holder—the company whose name they bore even though they were separate and very independent legal entities. "It caused a bit of a stir, but that was logistically important for us in order to coordinate our communications and to make certain that we were working with an organization that could really give us one answer for their company and muster all of their resources to the needs in our territory," says Jones. It was a condition, she adds, for responding to First Interstate's RFP.

"Unlike one-time vendor contracts, outsourcing contracts require a different mindset because these vendors actually are integrated into the company."

The RFP stage is important because it helps the company identify the most compatible candidates. Although reference checks are conducted, the RFP process prepares the vendor for one of several personal interviews. Many vendors say they appreciate the well-organized approach as well.

"A lot of those [vendors] have said how impressed they are with the level of knowledge we already have about their subject area and how professional the approach is." Jones says that the outsourcing vendors understand early on that they aren't dealing with a fly-by-night relationship.

Finding the right vendor for your company, even though it often can take a long time, pays off in the end. That was the case with Harvest Foods, Inc., says Robert Rough, executive vice president and CFO for the Little Rock, Arkansas-based retail grocery chain. With 54 stores, it employs about 3,100 workers.

Harvest Foods contracted with IBM's Integrated Systems Solution Corporation (ISSC) to allow the company to focus on its core business, have access to enhanced technology and skilled personnel and to reduce operational expenses, Rough explains. He warns that outsourcing shouldn't be used to address an organization's lack of basic understanding of technology or as a "quick fix."

Rough also advises that an organization's decision-making group include the chief financial officer, chief information officer, board members, the human resources officer and a general counsel. That body's commitment is essential, he says.

Although the search took six months, it resulted in a 10-year contract—long-term by most standards. The reason Harvest Foods opted for such a long contract, Rough explains, was to outsource the information systems, which included the installation of equipment such as scanners, cash registers, instore processors and other hardware that Harvest Foods could pay for over as long a period as possible.

Also during the solicitation stage, those who are experienced with outsourcing say that it's important to supplement the personal interviews with reference checks. Art Young, benefits manager for Hewlett-Packard, says that his organization did so when it outsourced some of its benefits and service awards functions. Checking references, he says, should not be underestimated. "You want to know how much [business the vendor] has—who their big companies were and how much volume they had," Young says.

Discard the vendor's standard contract.
Many vendors push to use their standard contracts. But Lacity, Hirschheim and others say that the key to successful outsourcing arrangements is building a company-or even site-specific contract. Often the vendor's contract is one-sided and only obligates the vendor to perform the same level of service that the company's designated department already provides.

Site-specific contracts are useful because the impact of outsourcing is manifold. It affects each company in many areas: economics, service, organization, procedures, technical services and corporate culture. Standard contracts may not take into consideration a company's individual profile.

Failing to make sure that the final contract fits your needs can turn outsourcing into a mixed blessing. In one case study of a bank that outsourced its information systems (IS) function, Lacity and Hirschheim illustrate the point. While senior management was happy because the outsourcing vendor had increased the percentage of online availability and response time, the lower-level users were dissatisfied with the arrangement because they no longer were able to contact an analyst to make changes to the system, but instead had to submit requests to a user-systems liaison group. Obviously, had the procedures been more clearly specified in the outsourcing contract, these problems may have been averted.

Nevertheless, the benefits of a successful outsourcing relationship are a powerful inducement for human resources departments and corporate management. The question, then, is how to avoid the pitfalls of bad outsourcing arrangements while reaping the benefits of the best.

Do not sign incomplete outsourcing contracts.
As a company and vendor become more anxious for the business relationship to begin, both can be tempted to close the negotiation prematurely. The outsourcing vendor, in particular, may pressure the company to sign the contract before all the details are specified. But since the vendor isn't legally bound to alter the contract later, it may never agree to change the original contract. Even if revisions are worked out, the process may cause more damage to the ongoing relationship than all the rush was worth. So in addition to specifying the services requested, outsourcing contracts should also include:

  • Designation of who does what
  • Performance benchmarks
  • A reporting system
  • Procedures for any unanticipated problems
  • Working arrangement (where and how)
  • Penalties
  • Duration of contract
  • Payment schedule
  • Cancellation provisions
  • Special clauses that cover arbitration, risk sharing, confidentiality and renegotiation.

Designating who does what is the best way to ensure that a company retains control, says Kathryn Devos, manager of employee services for Madison, New Jersey-based Schering-Plough Corp. Her company outsourced relocation, awards and incentives to obtain better-quality service for employees.

In negotiating with a relocation vendor, Devos warns that without a clear plan for marketing employees' homes, a corporation could end up taking a financial loss on a house. For example, the vendor may decide that the only way it can sell a home is by lowering the price. Meanwhile, the corporation is in the dark about how the home is being marketed. "You really have to force them into allowing you, the corporate person who's paying the bills, to have some say in what's happening to the home [in question]," says Devos.

She also advises that organizations conduct the accounting on site. Typically, a lot of work occurs in the background during a relocation process: giving equity advances to an employee, paying off a mortgage, paying the appraisal, paying for inspection and maintenance. All of those procedures require bills. If, for example, she gets a $150 bill for lawn care and Devos knows it's a small home, she can walk over to one of the accountants and immediately clarify the item.

Also, by having relocation vendors on site, Schering-Plough's employees now have one point of contact, instead of the 17 different people they were referred to previously. Because corporations always are subject to audits, Devos also insisted that all files be kept on site. "I wanted them here," she says. "You can either be hands-on or hands-off. But you can't be in the middle."

Because the company spends at least $20 million to $30 million annually in relocation costs, somebody in the organization has to follow the money. An account manager should be clearly designated, Devos says. When reports are submitted, someone in the company has to know what the numbers mean and understand each service charge.

Also, whether the vendor provides one or more professionals, the names of the vendor's outsourcing team should be reported to ensure strict dedication to the company. In situations where a vendor may want to subcontract out, these conditions also should be clarified in the contract. Jones, of First Interstate, says that organizations should include provisions that allow the company to approve or disapprove a subcontract relationship with any vendor other than the original outsource partner. In some cases, it might be approved only on a temporary basis until the original vendor can resume its services.

In terms of establishing performance benchmarks, the contract must be specific since either the company or vendor may wish to add, combine, improve or delete certain performance measures. But both parties might also want to allow some flexibility by inserting appendices, which is a legal term applied to all standard contracts.

Measures, according to Lacity and Hirschheim, typically require vendors to deliver a certain amount of work in a certain period of time. This applies to IS vendors and others. For example, 90% of all service requests may be promised within three days. But what about the remaining 10%? It may be serviced later or not at all. Despite the fact that 10% may never be measured, the outsourcing vendor has technically met its service-level measurement.

To avoid that problem, companies should specify 100% service accountability in the contract. If 90% is processed in three days, the remaining 10% should be completed, for example, in five days. Any exceptions should be fully documented and reported.

A reporting system also should be included in the outsourcing contract. Otherwise, a company can't be guaranteed that the services it expects have been provided. Organizations may choose to require weekly, monthly or even quarterly reports. Those decisions should be based not so much on convenience, but at what intervals those services are best evaluated.

In one case study covered by Lacity and Hirschheim, a security vendor's report indicated that "One hundred security requests were implemented this month." The report did not, however, specify how many were submitted or the average turn-around time for the requests. According to the contract, the vendor had met its service levels. But the users complained that security requests took more than two weeks to process. Reports, therefore, should quantify the agreed-upon service levels. Organizations might also want to design the reports so there is little room for fudging by the vendor.

"Many vendors push their standard contracts. But the key to successful outsourcing arrangements is building a company-or site-specific contract."

Because unforseen problems always arise, companies might also specify what procedures will prevail if services are unmet. Lacity and Hirschheim recommend that services be divided into critical and noncritical categories. For example, you might want to allow a vendor to miss noncritical measures (such as analyst training hours) once or twice a year. But for critical services (such as online availability), the company may require immediate reporting and a cash penalty if necessary. Those penalties for undelivered services also should be specified in the contract negotiations.

Some of those penalties may prove costly for the outsourcing vendor. For example, a commercial bank may invoke penalties between $25,000 and $50,000 if its data-processing vendor fails to meet end-user response time, system availability and batch-delivery deadlines for critical systems.

Although cash penalties never fully compensate the company, they certainly ensure that the vendor's senior management will attend to service-level problems. "Who's responsible if something goes wrong?" asks Young. "That's a sticky issue."

Protect yourself when negotiating the contract.
After most major items have been specified in a given contract, organizations also should consider including protection clauses for items such as special compensation, arbitration, cancellation, confidentiality and termination.

Correia, of Accounting Solutions, says that companies should set up parameters for special compensation. For example, companies sometimes want to hire key personnel away from an outsourcing vendor. Some contracts prohibit recruiting the vendor's employees; others allow the practice but set terms of compensation for the vendor. In either case, the point is to be honest and up-front in the working relationship. After all, people are what the vendors are selling, says Correia. And again, the role of HR managers is important because they are the ones to help cultivate a positive working relationship with the vendor.

Many companies also are reluctant to outsource because they don't trust vendors to protect their confidentiality or competitive information. Most outsourcing vendors work hard to defuse this issue. Accounting Solutions, for example, requests its temporary CPAs to undergo a professional ethics exam. But for highly sensitive or competitive information, companies should take more stringent measures. If, for example, the company is engaged in research and development, and the vendor is allowed access to privileged information, the company may want to request that all computer disks are returned. Both sides, Correia says, need to have an agreement about public disclosures. "You always think people have discretion, but it's better to put it in writing."

Because relationships don't last forever, or even as long as the original contract, most lawyers will insist that termination clauses be inserted to protect both parties. Either the company or vendor may need to terminate a contract because of bankruptcy, sale of a company or some other unforseen disaster. The main feature in such clauses is to specify the time period in which adequate notice is given. Failure to provide it also may result in a severe penalty charge.

Since negotiation with another vendor could take another six months and rebuilding an internal department could take up to a year, continued vendor assistance should be a requirement during the transition, regardless of who initiated the changing circumstance.

Assuming that there have been no problems with a vendor, organizations also will face the issue of outsourcing-contract renewals. Some critics of outsourcing say that companies have no other choice but to renew the vendor contract because the decision is long-term. In some cases, ceasing or changing vendors can be costly because you end up paying for some of the services twice. But if an organization has drawn up a detailed contract and established a successful working relationship with its vendor, renewals—even short-term—are most likely.

Another strategy for negotiating outsourcing contracts is to measure everything during a baseline period. That means documenting the company's current service level and using that as the yardstick to determine the vendor's obligations.

This procedure is different from the RFP in that the RFPs are merely high-level descriptions of service requirements. Baseline measures are much more exact measurements that, if not noted, can cause service problems and excess charges if items are unclear.

Moreover, an organization might want to anticipate its growth rate so it can share the benefits of price performance improvements.

In such areas as information systems, for example, the cost of a unit of processing decreases every year. If a company doesn't make its own projections, some information systems vendors could underestimate growth, which could lead to excessively high fees in the future. Says Rough, of Harvest Foods: "It's kind of tough when you're sitting there trying to figure out what your costs will be for the next 10 years. But you have to make the effort."

Although there are naysayers who claim that such projections are impossible to make, Rough argues that a company can't enter a long-term, 10-year contract without them. The company's negotiating team has to make some assumptions as to where it's going. "That way," Rough says, "you're comparing apples to apples."

HR sets the tone for outsourcing.
In many cases of outsourcing, companies have to displace employees. HR can help ensure that the company assumes social responsibility to treat those affected fairly. That means informing them of any final decision as soon as possible and helping them secure positions elsewhere, if necessary.

According to one labor mediator, the challenge for human resources is to create a temporary benefit package and provide job referrals or job retraining. For those remaining employees, the HR department must continue to raise the morale and resolidify the corporate culture around the changes. But in the best scenario, a vendor will consider retaining most of the employees in question on a trial basis.

As more and more companies continue to downsize and restructure for leaner times, human resources specialists will find that they are also asked to assist in companywide outsource planning. Whether or not HR's role is confined to its own department or it's participating companywide, the best approach to contract negotiations and any subsequent changes can be greatly facilitated by HR's communication skills throughout the process.

Besides the nuts and bolts of pinning down the contract's specifics, there is also an underlying attitude issue that must frame the process. Lillian R. Gorman, vice president of human resources at First Interstate, believes that flexibility and open communication is the key. Every professional relationship evolves and requires some give and take on both sides. A solid working relationship can yield a contract later on if a vendor wasn't chosen as today's provider of choice. "That's the spirit we want going into relationships. [Vendors] aren't just the hired guns asked to go out and fix something," says Gorman.

Personnel Journal, March 1994, Vol.73, No. 3, pp. 69-78.

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