Outsourcing is failing to deliver on the cost savings that are promised by many vendors – and expected by buyers – at the outset of a contract. Analysis by Compass of 240 live outsourcing contracts worth over £20m a year confirms that 65% of deals are unravelling before running their full term.
Rather than generating savings, this chronic level of failure can bring significant costs. Legal and advisory spend can escalate swiftly as business relationships on which operational continuity depends have to be unwound or renegotiated. More seriously, as the failed outsourcing project becomes a business problem, organisations face the costs of lost strategic options in the future.
A move to focus on the core business is often the driver for outsourcing. Yet in failing outsourcing relationships, we see organisations committing disproportionate amounts of scarce capital and their best people to getting projects back on track.
The study found that unrealistic expectations on the part of outsourcing clients can also distort pricing of deals and store up problems for the future. In the tender process, many suppliers face an unpalatable choice between bidding very low in the headline year one price or risk losing the deal (and writing off the significant costs of bidding).
This can lead to buyers putting unreasonable pressure on suppliers to offer lower pricing – which is likely to translate to lower service and investment later on. Compass’ analysis of deals has shown that outsourcing providers are typically pricing contracts to show immediate savings of up to 18% below the in-house operation they replace in order to win bids.
Some customers also seek to pass 100% of the risk associated with a project or operation on to an outsourcing supplier. In short, they seek to avoid paying the reasonable commercial risk premium that they would have to allow for if they ran the contract in-house.
But this commercial approach and the associated level of pricing is unsustainable over the long term, Compass warns. In addition to the costs of running the operation, outsourcers also have to cover the costs of winning the business, cover their own corporate overheads, allow for risk and cost of capital associated with a contract – and then generate a profit margin.
Some outsourcing vendors are clever but none are alchemists. Their people cost the same or more than in-house staff. Indeed, under the terms of many deals, the same people are employed as part of a transfer of undertakings arrangement. So with the same people and often the same business processes it is impossible to turn an operation into gold and generate profits – while still delivering lower costs to clients.
Instead, by the final years of a typical five to seven year contract, vendors are charging an average of 30% and sometimes as high as 45% above the comparable internal market rate for a given service.