Digital Transformation through Outsourcing

We are increasingly seeing two deal structures converging in a new and more powerful way to deliver non-core functions better, faster and cheaper. The two deal structures are “managed services outsourcing” and “digital transformation projects.” The result of integrating the two is “digital transformation through outsourcing,” which is structured to deliver a new level of benefit. In this article, we describe the benefits and gaps in those deal structures for delivering digital transformation, the integrated structure and ways to address certain challenges.

The Base Deal Structures

As background, below are high-level descriptions of the two base deal structures:

1. Managed services outsourcing. In a managed services deal, an outsourcing supplier takes responsibility for performing a non-core function for a long term for a customer in accordance with customer’s requirements for a reasonably firm price.
2. Digital transformation project deals. In a digital transformation project deal, a professional services supplier agrees to automate and otherwise replace a customer’s manual processes with digital processes, often with “bots” or SaaS services running on cloud solutions. The supplier generally performs an assessment to identify savings opportunities and executes those selected by the customer.

Managed services outsourcing is optimized for continuing to perform non-core functions in steady state. The supplier’s investment in performing the outsourced function (which is core for the supplier though it is not core for the customer) allows the supplier to bring greater knowledge, better tools, more experienced people and greater economies of scale. As a result, the supplier can perform with lower costs using its methods and share the resulting savings with customers. Also, the fixed price gives the supplier an incentive to digitize processes to increase efficiency.

However, a managed services deal may not result in digital transformation that benefits the customer beyond reducing monthly charges. There is a risk that the supplier will continue to run the function without change, despite changes in technologies and markets, using lower-cost labor. There is also a risk that the supplier will implement digital transformation in ways that adversely affect the customer’s overall business, and in fact, it is common for outsourcing customers to restrict change on the assumption that changes will be in the nature of “cutting corners.” Finally, there is a risk that the supplier will seek to lock in a renewal by transforming the function so that the customer at the end of the contract term cannot run the function as well or efficiently as the supplier can.

A digital transformation projects deal, on the other hand, is optimized for transforming core functions. The customer knows its core functions well, and thus can make good decisions on how it wants the function to be transformed and what is important for the deliverables. Also, the customer is able to control the program and select optimal investments.

However, a digital transformation projects deal works less well for non-core functions. In performing digital transformation projects, supplier benefits only from fees incurred and thus has little incentive to optimize the return on the customer’s investment. Like most IT projects, there is a long and unfortunate history of cost and schedule overruns on digital transformation projects.

Customers thus tend to seek prescriptive contracts and strong control rights, but there is a risk that the customer will not be able to make good investments because the customer does not know non-core functions well. Recognizing these risks, customers tend to contract for smaller projects, but doing so reduces the opportunity for holistic, end-to-end solutions.

The Digital Transformation through Outsourcing Model

A “digital transformation through outsourcing” deal may allow companies to reap the rewards of a collaborative partnership that improves efficiency, allows for liberation of internal resources and results in innovative technology that delivers benefits to the customer beyond the contract term. This may be a particularly attractive option for companies seeking a no-cost or low-cost way to fund a digital transformation program.

This deal model is evolving. At this writing, we see the following as characteristics of the value-maximizing “digital transformation through outsourcing” deal:

1. The supplier takes responsibility for performing the non-core business function as in a managed services outsourcing transaction.
2. The charges are based on the work completed—the outputs and outcomes—not billable personnel. This removes any incentive for the supplier to maintain manual processes to maintain staffing levels. (A variation on this approach is to have fees based on actual staffing but subject to a declining maximum that is based on outputs and outcomes.)
3. Different metrics apply to manual processes and automated processes. Thus, for example, there may be an “average response time” metric that might apply for services if a human responds. If a bot responds, the metric might be “percentage delivered without robotic error” or “speed of resolving user issue.”
4. The supplier retains all cost savings resulting from transformation in the outsourced function during the term. The term of the contract is long enough for the supplier to recover its investment in the transformation through those cost reductions. Termination for convenience charges may be used to protect the supplier’s deal-specific investments in lowering cost.
5. The customer has a clear right to take over the function at the end of the term in a manner that continues the cost savings. This may, for example, include the customer having rights to the process documentation, bot coding, SaaS services, configurations and other technology used in delivering the services. In certain instances, this may require a full “build, operate, transfer” outsourcing model.
6. The supplier is given substantial latitude to automate and otherwise improve the function, including by changes to customer systems, subject to processes designed to protect the customer.

The final point is among the most complex. The supplier generally has a reasonable need to change the customer’s ways of working, systems and processes to effect the transformation. The customer has a reasonable concern that the supplier might either inadvertently cause harm or implement a change with benefits to the supplier but adverse effects on the customer. The supplier, while wanting to make only positive changes for the customer, is concerned that the customer might delay or reject innovation to reduce risk or cost in the customer’s operations.

For example, the supplier might be taking responsibility for end-to-end accounts receivable (A/R) processing. The A/R system used is the customer’s ERP system, which includes licensed software and SaaS subscriptions. Supplier believes that substantial parts of the manual processes are repetitive enough to be replaced by bots. Those bots would be controlled by the supplier using master software working on the supplier’s systems. In that example, the customer might be concerned, among other things, about (1) a failure of the bots resulting in lost or delayed collections or harm customer relationships, (2) a data breach with the threat actor modifying the bots through the supplier, (3) the licensors and SaaS providers imposing additional charges based on users that are bots, (4) the customer’s ability to modify or upgrade its A/R system being limited because the bots only work with the existing A/R systems, (5) adverse effects on other digital transformation initiatives, or (6) inability to “take over” termination because critical aspects of the bots are non-licensed supplier technology.

This is a collaborative contracting model, so customers and suppliers should consider what they would do if they were a single enterprise. The following ideas are common:

1. Each change to customer systems requires approval by customer’s change control board, which will only be withheld for good reasons. Reasons to withhold approval include violations of customer’s technology standards or adverse effects on customer.
2. A designated committee with technical and operational members meets regularly to review program-level and project-level plans and approve other changes and detailed designs. An additional governance team, with technical and operational management, is available to streamline decision-making when issues arise and oversee the services and the supplier’s performance.
3. The customer agrees to help the supplier perform. In some cases, success requires that the customer provide technical support, access to systems, access to data and other information and cooperation necessary to perform the transformation (both from customer personnel and third parties). However, this mechanism can also be used to reduce cost (and thus charges) if the customer can help at a lower cost than the supplier can do the work without the help. In some cases, the customer may benefit by working side-by-side with the supplier to learn about the supplier’s digital transformation approaches and technologies.
4. Agreements by the customer to subscribe to third-party cloud services or license third-party software designated in the agreement at customer’s expense (which would also allow customer to negotiate its own terms with such third party) or as reasonably requested from time to time by supplier, if supplier bears the cost.
5. Agreements by the supplier to cooperate with changes performed by customer outside of the outsourced scope or provide resources customer at rate card rates for projects designated by customer. For example, if the customer changes its systems in a way that requires changes in the supplier’s bots, the supplier might be agreed to make the required changes at no charge up to a threshold and at customer’s cost over that threshold.

Challenges of Digital Transformation through Outsourcing.

As with any novel deal structure, there are challenges in negotiating a digital transformation through an outsourcing deal. While this article reflects the view of the authors that there is an emerging best practice, others may have different views. Also, of course, suppliers would find it advantageous to contract without many of the customer protections described in this article. However, there are a number of ways for companies to optimize the negotiation process and overcome the typical challenges. Those include:

1. Leveraging competition between bidding vendors. While it can take significant effort to negotiate against multiple bidders, the customer can benefit from leveraging other bidders’ proposed deal terms and contractual terms, as well as foster a sense of urgency, which often help to achieve better pricing and reduction of contractual risk. This is particularly valuable in this type of deal, where it is difficult to assess the possible opportunity other than with a market test.
2. Taking a risk-based approach focused on enterprise benefits. Digital transformation through outsourcing implies a substantial commitment and some loss of control over a part of digital transformation. Thus, consider many scenarios in the business case. For example, a low fixed price for a long term may be valuable, but only if the expected volumes appear.
3. Considering alternative payment structures to fund investments. This could involve, for example, paying one-time transformation costs over several years. Similarly, it might involve “paying” the supplier by allowing the supplier to use its work product, or even the customer’s technology, for other clients.
4. Investing time and resources into securing a strong contract. While it may seem easier in the moment to sign a vague document and sort out details later, that creates an opportunity for the supplier to demand price increases later for adding contractual clarity. A strong contract secures commitments to deliver the needed services as required for a reasonably firm price, avoid harmful change, and permanently lower the cost of the outsourced function.

With the necessary level of commitment, research and creativity, your company can harness the full scope of opportunities presented by digital transformation through outsourcing and enjoy the benefits of a strong deal for years to come.