Risk-reward based outsourcing

SAIC VP and BP global account manager Meyrick Williams believes that the secret to successful outsourcing is to promote profit, not penalties. In this contributed article, Williams explains how to make outsourcing deliver high rewards with low risk. The secret is to move from inflexible, contract and penalty-based outsourcing to a trust-based, risk-reward agreement which offers incentives for performance and innovation.

The outsourcing bandwagon is gathering speed as companies realize that it’s often more cost-effective to cede control of certain functions to a specialist third party, letting them concentrate on their core competencies. Tom Peters’ business mantra that “you’re a fool if you own it” now reverberates in boardrooms the world over. Over the past half decade, in manufacturing facilities, management skills or software, the market for ‘renting’ business elements has grown into a multi-billion dollar industry. A move to outsourcing frees up internal resources to focus on winning and retaining business, provides more flexibility and offers a variable cost base. Companies get greater access to a wider resource base and more skill sets, not to mention the economies of scale derived from effective outsourcing.


In business utopia, this would ensure we all live profitably ever after. But things don’t work out like that. Any partnership depends on compatibility, with needs, culture, cost and other variables. What might be right for one may not be for others. The key is to strike an effective balance. What makes a successful relationship? To investigate this, lets take a look at two models—the ‘contract model’ and the ‘risk-reward’ model.

Contract model

A typical contract model for IT outsourcing involves a fixed-base charge for a defined scope. Objectives are set at the outset and the supplier is expected to deliver on time and to budget. As the market is continually evolving, the initial scope is likely to change. Any changes throughout the term of the contract are handled on a fixed unit charge basis. But this creates adversity and limits flexibility. It doesn’t leave much room for maneuver. Incentives may even encourage the supplier to increase costs and usually fail to improve services or evolve technology. This model can work, but is most likely to be used for ‘commodity’ services.


But there is something lacking in the contract model. Outsourcing relationships should be more than just a contract. In a truly two-way relationship, there is an unspoken commitment to work through any hard or tricky issues that arise. A partnership based on trust produces win-win behavior and provides mutual benefits through the alignment of business objectives. An outsourcing relationship must be flexible in order to handle changes as the businesses evolves.


An alternative outsourcing arrangement involves setting mutually agreed targets and incentives to encourage teams or individuals to exceed on their personal objectives. Good performance is rewarded and both teams are continuously motivated. An open book, or risk-reward agreement, where there is transparency in what both parties are doing, is far more likely to succeed than one where some elements are kept behind closed doors. In fixed-price contracts all savings become profit to the contractor. However, in target-based risk-reward, the savings and benefits are shared.

How it works.

An open, cost-based contract providing a basic set of services is agreed upon and a target cost with a base fee is estimated for the activity involved. As an incentive, share ratios are then negotiated for over-run and under-run of the cost target. Clients can also offer to pay additional incentive fees to encourage certain behaviors - for example, delivery in line with agreed SLAs, service and technology innovation, customer satisfaction, co-operation with other suppliers, benchmarked performance against market metrics and seamless delivery during transition.


Often a certain amount of money is taken off the overall sum for every day over-target that a project runs late, although this type of contract doesn’t rely on penalties. In fact, neither party wants to enforce or incur them. That’s missing the point. They’re purely there for insurance, so any company who feels they are unable to hit targets should either negotiate harder or decline the contract.


For this model to work, it is important that annual target prices are set. For example, the target for Year 1 is based on the actual cost history and current budget information provided by the client and verified in due diligence. In taking this approach, it allows a much faster start in provision services than a typical contract.

Open book

The partnership model is based on open book accounting. This means the client is free to audit the account records and there are no secrets between the two parties. This is essential to success, and ensures that trust can be won by proving yourself in a totally transparent manner. The outsourcing scenario will also include meeting SLAs, customer satisfaction surveys, IT and business management reviews, overall quality, innovation, co-operation and risk.


Incentive-based (not just penalty-based) contracts of this sort are designed to minimize risk and maximize results. Good communications and sound working relationships are key. Knowing where both parties stand provides a solid basis from which to move onwards and upwards. In an unstable economic environment, this is as near to guaranteed performance and return on investment as you’re likely to get.

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