Outsourcing process design and contracting conundrum

Over the past decade, companies have looked towards external partners to deliver a lot of business processes. IT support, BPO (Business Process Outsourcing), transactions, KPO (Knowledge Process Outsourcing) including R & D have been outsourced by companies to external partners.

The BPO expenditure globally for 2011 has been estimated to be $153 billion. Zhijian Cui, Assistant Professor of Operations Management at IE Business School, Sameer Hasija, Assistant Professor of Technology and Operations Management at INSEAD and Arijit Sengupta, MD and founder of Argon Services, take a look at how corporations can effectively choose the right service providers under the right servicing contracts.

outsourcing contract. Image source englishdom.com

Core of outsourcing process design: contract effectiveness and provider selection

The success of an outsourcing process depends on the choice of the service provider and the effectiveness of the contract drawn up. A client ideally wants the best service provider with minimal information rent. However, a survey by ISG states that contracts generally deliver about 28 percent less than the originally anticipated value.

The client usually chooses a service provider by a formal RFI (request for information). The potential providers are shortlisted and chosen based on this information as well as industry opinion and secondary research. However, it is very difficult to understand if the chosen service provider has client specific abilities. If the service provider does not possess such capabilities, the project can even lead to failure.

On the other hand, effectively structuring a contract is also crucial. This depends on the client’s understanding of the provider’s capabilities and vice versa. A poorly structured contract can lead to substantial (and disproportionate) information rent by the vendor.

The contracting conundrum: Trade-off between contract effectiveness and provider selection

It is not practically possible to achieve a good service provider and an effective contract simultaneously. If the client follows a process from which a good service provider can be chosen, the contract structuring undertaken will end up poorly. On the other hand, if the client focuses on drawing up an effective contract, compromises will have to make on the choice of the service providers. This is known as the contracting conundrum in outsourcing which is a trade-off between a good service provider and effectiveness of contract.

A good service provider can be selected by clients through competitive bidding. This will help reveal the true capabilities of the providers. The client can choose the best suitors and frame the contract based on the bid made by the chosen service provider. Even though this ensures a quality service provider, it can eat up on the profit margin of the clients since choosing the best bidder can cost a lot.

If the client decides to focus on the contract effectiveness, the company can engage in contract negotiation after choosing a service provider. This will not ensure that the service provider chosen will be optimum for the project.

Clients outsourcing standard processes tend to end up with good service providers and weak contract structure while the opposite happens for clients outsourcing customized processes.

How to escape contracting conundrum?

The best method of escaping contracting conundrum in outsourcing is to retain flexibility in contract negotiation. If the service provider does not seem to suit the client-specific skills, the client can jump to another service provider. This ensures reduced information rent and better service provided. However, switching providers in the middle of negotiations can incur additional costs.

Provider selection and structuring contracts is an interlinked, multi-stage and very complex process. However, for clients to succeed in their projects, they have to ensure that a sound outsourcing process is designed, addressing the contracting conundrum effectively.

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