30 September 2010
Innovation is often considered the Holy Grail of outsourcing contracts. It is touted as one of the key benefits of engaging with providers who are expert in their fields and who have portfolios of customers from whom to draw inspiration. In reality, however, finding innovation beyond cost reduction has been elusive, and customers who expect it are frequently disappointed. Why has this been the case, and what can be done to bring the promise of innovation to reality? While we cannot provide definitive answers to those questions, we can offer insight based on observations of what some successful companies have done and offer alternatives for building innovation mechanisms into your contract.
Why Have Outsourcing Deals Failed to Produce Innovation?
Our research indicates that outsourcing contracts do not foster what customers call “innovation” because customers have not put a priority on innovation when they outsource. Instead, customers have focused almost entirely on immediate cost savings. Pricing, milestones and incentives are designed to reward the provider for “keeping the lights on,” but not for exploring new areas for efficiencies. Providers respond accordingly in their proposals, solutions, staffing and governance. The result is low cost solutions but also low levels of innovation.
Make Innovation an Essential Part of Outsourcing Deals
Reducing cost can justify outsourcing. However, many companies are losing the opportunity to get ideas and help that can improve their operations generally. Additionally, as companies outsource a greater portion of their internal operations, they increasingly lose the subject matter expertise that fuels internal innovation. Without the internal expertise needed to produce innovation, these companies must rely on their providers. There are instances where customers have brought some or all of an outsourced function back in-house precisely out of concern for innovation. As outsourcing grows to play a more prominent role in corporate strategy, so must innovation play a more prominent role in outsourcing contracts.
Where Has Innovation Worked?
We have seen cases where innovation by providers offers meaningful, lasting value to a customer. The innovation may be an improvement in the delivery of the provider’s services, but it may also be a change in the services that allows the customer to improve other related functions that were retained by the customer. Or, the innovation may be entirely unrelated to the provider’s day-to-day services.
From our experience, the most successful innovation arrangements contain clearly defined business objectives, a specific process for collaboration between customer and provider, and financial incentives that promote the development of innovation proposals and the implementation of resulting projects. These successful arrangements also include corresponding governance structures and management support.
Contract Structures for Innovation
There are several contract mechanisms that can be used individually or in combination to promote innovation in an outsourcing contract. These range from general commitments to specific undertakings with financial incentives.
COMMITMENTS TO TECHNOLOGY EVOLUTION
The most common innovation provision in outsourcing contracts is the general commitment to technology evolution. This requires the provider to keep its technology current with leading providers of similar services. In addition, the provider is obligated to conduct periodic briefings with the customer to discuss new technology opportunities that may apply to the provider’s services and to develop proposals on specific technology when requested by the customer.
The difficulty in applying the technology evolution provision is determining when a new technology is a new service to be paid for by the customer, and when it has evolved into a standard that must be adopted by the provider without additional compensation. There is no clear demarcation, and there is plenty of room for differing opinions. There is also a risk that a provider will refrain from discussing potential innovations to avoid being compelled to provide them without additional charge. Consequently, this type of provision is more useful for protecting against stale provider assets than for ensuring innovation.
PROJECT PROPOSALS FOR SPECIFIC OBJECTIVES
A more precise approach to innovation is to obligate the provider to make project proposals to accomplish specific objectives (e.g., virtualization, user provisioning, green initiatives). Such a contract provision would also describe what the provider’s proposals must include, such as a detailed project proposal and a financial benefit analysis. This approach is more likely to promote innovation because it provides specific targets for the provider’s efforts.
One disadvantage to this approach is that it limits the objectives to those that can be identified at the time of contracting. In addition, this approach yields only project proposals, leaving the funding and valuation of the proposals to be determined. Therefore, while the project proposals can offer real value, the likelihood of value creation can be enhanced if proposals are combined with commitments for funding and cost savings.
SHARING OF PROVIDER’S INNOVATIVE TOOLS
As experts in their fields, providers use innovation to build tools and processes that help them perform their functions more effectively and efficiently. One relatively simple approach to innovation is for the provider to share some of these tools when the customer would benefit from their use. The kinds of tools that fall into this category include productivity, analysis and training tools. The provider would train the customer on the use of the tools and provide change management assistance to implement them.
One caveat to this sharing arrangement is that providers understandably will be concerned about protecting their most valuable tools. The customer has a countervailing interest in maintaining a uniform environment for itself and its other third-party consultants and contractors. The contract protections would have to balance these two conflicting interests.
One way to ensure investment in innovation initiatives is to fund those initiatives. The outsourcing contract would specify a dollar amount that the provider will make available to fund innovation work. Some or all of this amount will naturally be factored into the provider’s charges and will be passed on as charges to the customer. Thus, the customer must value the innovation benefit before adding this type of provision.
The provider, however, will probably not increase the customer’s charges on a dollar-for-dollar basis, since part of this cost would displace marketing costs that the provider would otherwise incur. In addition, the provider would likely bank on some added revenues from the resulting projects.
A contract funding provision, then, would typically identify what can be funded and would specify the governance process for making such decisions. Potential innovation initiatives can range from workshops and technology reviews to spur creative ideas to consulting services designed to implement those ideas.
COMMITMENT TO COST SAVINGS OR REVENUE GENERATION
Process and funding do not, in themselves, ensure outcome. Hence, one additional contract approach is to include a commitment by the provider to achieve defined levels of cost savings or added revenue.
A few obvious complications arise: How can providers ensure an outcome such as net cost savings when they do not control what opportunities the customer will fund and implement? One way to address this gap is to credit the provider with net savings for a project, if warranted, even if the customer elects not to implement the provider’s idea.
This approach is feasible for projects that yield hard cost savings, but it can be difficult, if not impossible, to assess the projected revenue or soft cost impact of innovations without empirical evidence. In either case, we recommend that the parties agree in advance on accounting rules and procedures to measure the cost or revenue impacts of projects.
Finally, in order for a commitment to cost savings or revenue generation to be meaningful, it must be attached to a financial consequence if the provider fails to achieve it. Such a consequence might take the form of a credit for some or all of the shortfall.
An additional incentive to promote innovation is gain-sharing. Gain-sharing provisions have been a staple in outsourcing agreements, but they typically have little effect because they usually are not accompanied by any specific commitment or process. These provisions have relied instead on the parties’ future agreement on subject matter and scope. This caution in the use of gain-sharing is perhaps driven by cases where commitments to gain-sharing have resulted in a windfall for the provider when the provider shared in cost reductions that resulted solely from market shifts in commodity prices (e.g., reductions in telecom rates).
More advanced gain-sharing commitments have been structured in ways that produce substantial benefits. One approach is to combine gain-sharing with the structured process described above for valuing cost savings and added revenue. The result would be a provider commitment to first generate a minimum savings without gain-sharing, then to share in savings when they exceed a higher threshold. Another approach is to define a precise scope for gain-sharing. For example, a provider might have the right to share in gains from re-negotiating certain third-party contracts or from modifying specific processes or technologies.
ALLOCATION OF INTELLECTUAL PROPERTY RIGHTS IN INNOVATIONS
The final ingredient for innovation is the allocation of intellectual property rights. If either party is concerned that its assets or competitive position will be compromised or forfeited by the collaboration, they will not volunteer their most valuable ideas or intellectual property, and the creative process will suffer. Conversely, a party that believes it could gain rights to valuable innovations will put more effort into creating those innovations.
Finding the right balance is difficult. The rules can be complex and can vary depending on the parties’ business models and industries and their relative contribution to any particular development. We know from experience that this issue can be successfully tackled, but it must be addressed at the start and not as an afterthought.
Governance Structures for Innovative Outsourcing
Innovation is not something that the provider delivers. Rather, it is the result of a multi-disciplinary creative and collaborative process that requires active participation by both provider and customer. The benefits of this process may cross organizational boundaries and may extend beyond the outsourced function. It is inherently unpredictable, and for every success there will be failures. Management needs to be prepared for this, and the governance process must be designed to support it with practices consistent with those used to foster innovation internally.
Innovation is an essential ingredient for corporate survival and growth. As companies expand their reliance on outsourcing, they also must integrate innovation as a critical component of their outsourcing relationships. Providers’ success will also depend on their ability to be a source of innovation for their clients, as only those relationships that include innovation will survive in the long term. When combined with management support, the right contract provisions can provide the structure, process and commitment needed to bring the promise of innovation to reality.