The Wall Street Journal article dated June 16, 2007 and entitled “The Seven Myths of Outsourcing” (at this link) is a great survey of significant issues arising in outsourcing deals. While it points out certain major flaws in the deal-making process, however, it fails to scratch below the surface to the misaligned incentives that give rise to this deal structure. Understanding those reasons is important, too, as seemingly illogical behaviors often has perfectly rational explanations underlying them.

Below is my note to the authors of that article - a note that offers some insights into the incentive structures that can create these difficult deals and deal structures.

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Dr. Puranam, Mr. Srikanth:

I read with interest your article called “Seven Myths About Outsourcing,” and materially agree with all of your comments. As an attorney practicing in this area, I have seen nearly all the myths in action - and have had to deal with the fallout of each of them. In reply, I’d like to offer a couple of additional comments - and a methodology that I’ve been working on (to be added to my web site in a few days).

With regard to your first myth, “we can have it all,” fault lies clearly with all parties in an outsourcing deal. First, as you mention, Vendors regularly over-promise, claiming capabilities to do nearly everything. Customers, however, are also significantly at fault - to get the deal approved internally, they often have to make internal promises that are contradictory - to satisfy the CFO, financial savings; the divisional president, new capabilities; the CIO and audit, additional control, etc. Advisors, too, are reluctant to tell the truth - that the customer can’t have it all, for fear of looking like naysayers.

The “commodity” myth is interesting. My experience has taught that over-involvement of corporate procurement groups, with their focus on commodity purchases, is often the cause of this problem. The intra-company wrestling match between a centralized finance group (generally represented by procurement) and a disparate executive group often results in procurement taking the lead in a deal that they are poorly organized and educated to run.

The “contract” issues that you mentioned are truly interesting to me - as an attorney, that is the main part of my involvement in these deals. Law firms and outsourcing consultants love the 1,000 page deals - frankly, the papering and repapering of them generate lots of fees. These voluminous deals also generate repeat business - as it is nearly impossible not to operate in breach of the agreement. One way to address this, and a way that I strongly suggest when possible, is to focus on lines of demarcation, rather than on detail lists. When successful, this approach can both simplify the deal paper and make it more governable.

As to operating on an LOI or without a contract - I agree that it is a bad idea, but one that is often created by necessity. Customers planning an outsourcing go through several phases before the deal is done. RFP’s, save analysis, socialization, etc. Dates are set, HR is put on the ready (if there are reductions in force planned), and word inevitably gets out. Then the “deal team” begins slogging through. Procurement, legal, outside consultants and outside counsel begin this process that can take months - pushing the delivery dates and delaying the major benefits, be them savings, capabilities, product launches, etc. Vendors know this, too, and are more than willing to keep moving slowly - after all, beginning operations under an LOI gives them the ability to better protect their interests in the contract negotiations - they are at that point an incumbent. Simplifying the contracting process can help this significantly, but also better planning and fewer up-front deadlines are helpful.

Risk allocation is an interesting point. While I agree that vendors are not insurance companies, it is also true that they must reasonably shoulder the risk of their own malfeasance. Your point about Ford is, in some ways, correct - Ford was primarily liable to its customers. That being said, it is quite likely that the supply contract between Ford and Firestone contained an indemnity that may have protected Ford - had Firestone not gone bankrupt. In general, I try to take the approach that a party in an agreement is responsible for its own actions - and that the vendor has to reasonably be responsible for the acts or omissions of its employees - particularly acts of malfeasance. All too often, vendors seek to eschew the responsibility to take responsibility for their employees - in a way that can be very troubling. However, one thing that few lawyers advise their clients to do is to really take a look at the likelihood of the risk (this occurs on both sides). Risk analysis is treated as if the problem is 100% likely to happen - and that scare tactic frightens both customers and vendors. It would be far more productive, I believe, to analyze the real exposure (amount times likelihood) and determine the cost/value of “insuring” against that risk.

I love the “it’s not our problem” comment - here often stated as “out of sight, out of mind.” While the risk issue, above, talks to “big” risks, this item really speaks to the day-to-day risk of running an operation. Outsourcing a function, with management approval, etc., creates an interesting managerial incentive to “forget about it” in many organizations. If all senior management thinks that “out of sight is out of mind,” taking that approach, as an executive with operational responsibility, can provide an easy way to point blame to the vendor for failed operations. Cynical as this is, people are as often motivated by their own job security goals as they are by corporate health. Accountability is a fluid issue in many organizations - and pushing accountability to third parties can be viewed as a way to keep one’s job.

Finally, I agree with the the first failure analysis. I advise clients to start small, learn the process, learn how to manage outputs (rather than their normal approach of managing inputs), and refine the process. Unfortunately, however, outsourcing is driven by the promise of short-term cost savings - and those savings (whether real or illusory) only really accrue in large efforts.

Now, to my methodology. I have developed this after several years of practice in this area - and living through many of the faults. The methodology is really a form of gap analysis intended to provide a framework for understanding contract and business issues - both at the outset and during the life of the deal.

The framework is called “FAIR” and stands for “Financial Responsibility,” “Accountability to third parties,” “Information” and “Responsibility for Performance.” Analyzing processes, risk allocation, etc., by focusing on these four factors can provide insight into gaps between customer and vendor - and can provide the basis for resolution. Ultimately, this approach can further incentives to communicate regularly and in a non-adversarial manner - the only real way to improve the outcome of these deals.

Using a governmentally-regulated process as an example, lets imagine a health insurance claims process. A claim is sent to the outsourcing provider for processing. During this process, the Customer has financial responsibility and accountability (to third parties), but the Vendor has most of the information and the responsibility for performance. With this framework, it is easy to understand why the customer may be particularly concerned about the process and want additional incentives for proper performance and “insurance” clauses - they are accountable to a third party, but lack the means or information to govern performance.

In other areas, where the customer has more information or less accountability, the concern may not be as great - and the contract gaps are likely more easily closed.

Best regards,
Gary M. Zeiss, Esq.