The Winner's Curse
22 February 2007 Andrew De Cleyn
Andrew de Cleyn, LogicaCMG, explains how to avoid the pitfalls of jumping headlong into outsourcing commitments.
Outsourcing non-core activities is now standard practice for many businesses. When performed in the right way the financial rewards can be extensive. However, in the hunt for the biggest savings in striking outsourcing deals many companies leave themselves vulnerable to the 'winner's curse' – contracts that excessively favour the client to the detriment of the supplier.
This is the finding of a new research-based whitepaper by Leslie Willcocks, professor of technology, work and globalisation at the London School of Economics, sponsored by LogicaCMG. Why should the winner's curse be avoided and how can CEOs steer clear of it?
Successful outsourcing is not about getting the lowest price at all costs. It is about getting the lowest price for a suitable solution under a fair contract from a qualified service provider. At the point of contract negotiation CEOs have the upper hand in selecting outsourcing suppliers. This advantage in bargaining position is often used to acquire the cheapest service. However, this new research shows that simply securing the cheapest option is not always the most financially rewarding decision.
When costs are so low that the supplier cannot make its margins, the outsourcing relationship is likely to become riddled with financial and operational difficulties. In 2002 one in five outsourcing contracts fell foul of the winner's curse. Of those contracts affected, 75% of the clients felt the long-term backlash of acquiring the services of suppliers for too low a price.
In reality, the outsourcing options that are initially cheaper are not only the most unstable and most poorly implemented, but are very often the least cost effective.
CHOOSING A SUPPLIER
In choosing the best supplier using qualitative judgements, decisions should not be taken solely on the basis of the physical resources – material and human assets such as facilities, technologies, tools and workforce – of a potential supplier. These are fundamental attributes but they add very little to the possibility of a stable and mutually beneficial working arrangement.
When looking for a service provider CEOs must ensure that they do not let the initially impressive amount of physical resources controlled by a supplier fool them into believing that it will translate into the most appropriate service.
That attractive physical resources play a major part in the decision-making process of selecting a supplier is only natural given that it is these physical resources that are most visible on site tours, balance sheets and résumés. But, companies should be more interested in the suppliers' ability to turn these resources into capabilities that in turn can be combined to create high-level customer-facing competencies.
To get the best outsourcing contract and avoid the winner's curse, CEOs must be able to pick the most cost-effective outsourcing solution, weighing cost not against physical resources but against the competencies and capabilities exemplified by the supplier.
Professor Willcocks's white paper highlights 12 key capabilities that CEOs should be on the look out for when deciding upon potential outsourcing suitors:
- Leadership – the capability to identify and deliver overall success throughout the deal
- Business management – the ability to deliver in line with the service agreements and the supplier's and client's business plans
- Domain expertise – the capability to retain and apply professional knowledge
- Behaviour management – the ability to motivate and inspire
- Sourcing – the ability to assess resources as required
- Process improvement – the capability to incorporate changes to the service process
- Technology exploitation – the capacity to swiftly and effectively deploy new technology
- Programme management – the capability to deliver a series of related projects
- Customer development – the focus that the supplier puts on the developing needs of the client
- Planning and contracting – the ability to communicate their vision for the potential reward to both parties and a coherent process for achieving it
- Organisational design – the ability to design and implement successful organisational arrangements
- Governance – the capability to track and measure performance
Fundamental to all the 12 competencies highlighted by the white paper is a workforce that is properly skilled, experienced and motivated. Finding an outsourcing company with such a workforce should be a primary consideration when selecting an appropriate supplier.
THE THREE COMPETENCIES
All 12 capabilities fall into three distinct competencies that, if used as a guideline when selecting a supplier, will help companies avoid the winner's curse and the lure of impressive physical resources.
The first is a delivery competency based on the supplier's ability and willingness to respond to a customer's day-to-day operational needs. The second is a transformation competency based on the supplier's ability to deliver radically improved services in terms of cost and quality. Finally, and most elusively, there is a relationship competency based on the supplier's capacity and willingness to align itself with the customer's values, goals and needs.
However it is highly probable that that each of these competencies will be sorely lacking in a relationship where the supplier is providing a service so low in cost that it fails to make its margins. Opting for a supplier solely on the lowest cost is likely to mean that the supplier is unable to fully leverage these added value capabilities, as its margins will be squeezed too far to make this viable.
For this reason choosing a supplier on lowest cost alone is likely to limit the chance of a healthy, cost-effective and mutually beneficial business relationship.
THE FUTURE OF OUTSOURCING
Looking to the future the white paper makes a number of predictions for changes that the supplier market will undergo.
Given an awareness of the dangers of contractual short-sightedness, discerning CEOs will force global suppliers to evolve in order to stay competitive. With lowest price ceasing to be the primary factor, suppliers will have to reposition themselves, restructure their cost base, diversify their services and expand their customer base in order to stay competitive.
Also predicted is a shift in location of captive centres to low-cost, high-value economies such as China and Eastern Europe in order for large global suppliers to stay cost-competitive while Indian suppliers translate their significantly higher profit margins into high-value, high-touch services.