Outsourcing - What A CFO Needs To Know

Article by London partner Andrew Moyle and associate Martin Cotterill

Financial directors around the world are looking at outsourcing to drive down operating costs, drive up shareholder value and accelerate the pace of change that today’s unforgiving economy increasingly demands. Achieving the financial and strategic aims of an outsourcing is not a given, there are some practical pointers you need to consider along the way.

These days it is unlikely if there is a CFO in any major organisation that has either not had exposure to outsourcing, considered outsourcing or who is in financial control of a business who has outsourced. Indeed the number of companies who have not outsourced parts of their business is rapidly diminishing. With more than 113 out of the Fortune Global 500 publicly announcing outsourcing deals worth a collective $250 billion¹ to date, it is a business tool that no one can afford to dismiss without serious consideration.

What perhaps is unsettling amongst all the statistics on outsourcing is that no-one, anywhere can tell you, in concrete terms, how good or bad those deals turn out to be once they are implemented. Typically it’s bad news that makes the news but, bar a few headline-grabbing exceptions and camp-fire tales, deals that do go wrong are rarely publicised. What we do know is that these deals will go wrong for two principal reasons - poor construction and lack of management attention. The first is about getting good advice and running a strong process to deliver a balanced deal. The second is recognising the impact of an outsourcing transaction on the retained customer organisation and planning for that impact and the corresponding investment that must be made to ensure its success.

When Latham & Watkins start outsourcing projects with our clients many initial discussions with the CFO’s of those organisations focus on the key areas are that need to be considered at the outset of a project. Consideration of these questions in turn leads to the formulation of the strategy to avoid, amongst other things, falling into the traps that can lead to deals going wrong. In this white paper we have encapsulated some of the key areas that appear in almost all outsourcing deals, and the most common areas of concern that are typically of concern for CFO’s.

1) Recognising the nature of the deal is perhaps the first hurdle, these deals are not corporate disposal and lease-back transactions, but are long term business service arrangements. To treat such a deal as an M&A type of transaction is to miss the fundamental distinction that what you are transferring out and buying back is your own business. You are handing over control not ownership of the functions you outsource.

2) If you step back and analyse the outsourcing proposition, your organisation is usually asking a supplier to:

• run a part of the business that you understand better than they do;
• re-engineer the functions that are outsourced; and
• do everything at a lower cost, usually after VAT.

3) The culmination of the outsourcing process is the production of a contract that needs to reflect the dynamics of your particular transaction, particularly in the three main interlinked areas: scope, service levels and price. Whether you are looking at IT outsourcing, business process outsourcing or business transformation models, the finance function should understand and be an integral part of steering the deal. This means understanding the dynamics that link and influence these three components.

4) You are handing control of a part of your organisation over and the only constitution of this ongoing relationship is a written one in the form of your contract. The processes within and interfaces to the outsourced functions must be articulated and formalised, but for many organisations these will not be written in a way that contemplates a different company operating them. This shift from a wholly internal focus to an arms length transaction demands an organisation to look at the policies, procedures and even daily custom and practice that operate within an organisation. After all you will want your outsource provider to provide its services in a manner that complies with your policies, procedures and practices. Are you able to provide all of this information so that the outsourcer can design their service model appropriately?

5) Many suppliers push for quick implementation of a contract with minimal due diligence up front, leaving the verification of price, scope and service levels until after the contract is signed. From a customer’s perspective this should be strongly resisted and the reason is obvious: (i) Your negotiation leverage will deteriorate significantly once the contract is signed, the business has transferred and your people have gone; (ii) barring a material breach by the supplier you are effectively locked in; and (iii) in these circumstances your ability to then agree a favourable price and meaningful service levels after contract signature has been seriously reduced. Designing a service model in the midst of the transition of those services can spell operational disaster and missed expectations. Operationally it can, and often does, drive the wrong behaviour out of a supplier who may focus solely on the "low hanging fruit" or the quick wins to make the right initial impressions, often at the expense of the longer term goals. Even business transformation outsourcing transactions, which are built upon the premise of organisational change through an ongoing programme of initiatives, require up-front planning and validation so that the right outcomes of the transformation programme are captured and understood.

6) Whatever the underlying reasons for outsourcing, the need for your chosen supplier to understand what it is that they are taking on, and for you to understand what it is you are buying, is critical. Failure to deal with this as a part of the contracting process through well defined and negotiated scope, pricing and change mechanisms often results in the failure to deliver to expectations in the implementation stage. This takes effort and therefore cost in advance of a contract being signed. The mobilisation of your own internal and external experts and advisors to manage this process should therefore be budgeted for, but is often under-estimated.

7) With these considerations in mind, entering into an outsourcing arrangement without performing a rigorous cost / benefit analysis, due diligence and careful construction of the deal up front places too much reliance upon platitudes of a "partnering" relationship which can ultimately lead to a strain upon that relationship. Nothing polarises an informal relationship faster than a dispute arising in a failing outsourcing arrangement. A clear contract will enhance both party’s ability to maintain the relationship through robust processes to deal with issues that will arise, without detriment to the service.

8) At the end of the term of the deal your retained function will be focused on buying not providing these services. The natural attrition in retained know how over, say, a five or possibly even 10 year term is therefore obvious. Accordingly your ability, at the end of the contract, to re-transfer the functions elsewhere, either to a new service provider, or back in house, will be critical. These deals have a "super-tanker effect," you cannot simply apply the brakes and expect to stop and transfer out. Added to this is the commercial imperative of avoiding over-dependence upon an incumbent supplier and structuring the agreement so that this is avoided by ensuring that, amongst other things, you establish:

• detailed exit management provisions which include parameters for dealing with assets, subcontracts, personnel and information on a transfer; and
• appropriate rights in the intellectual property created by the supplier during your contract term so that you can continue to run your business without paying a premium for securing the rights you need; and
• a pre-defined price if you decide to exercise your right to terminate the contract for convenience, to enable you to exercise the right without having to negotiate your way out.

9) An essential pre-contract requirement is to build the financial model of the deal so that an analysis of the costs over the term of the deal can be performed. The challenge for an organisation is building that financial model in such a way that they are comparing like-for-like when comparing existing and projected costs against a supplier’s price. There are a few key considerations in most outsourcing arrangements that will ultimately dictate the level of confidence you can place in the prices you receive and the analysis you can conduct:

• suppliers will quote a price based primarily upon the level of detail of the scope you provide them and the performance levels you require;
• what assumptions have been made in relation to the volume bases for the supplier’s price? What is the flexibility in the price if those volumes increase or decrease?
• the base case costs, against which you benchmark, should include a quantification of all the factors that are built in to your outsourcing strategy as communicated to your outsource suppliers (e.g. technology refresh, asset transfer, business volumes); and
• outsourcing deals don’t manage themselves and there is a cost to the retained organisation of establishing its own contract management structure.

10) In most cases your financial analysis will drive the fundamental structure of the deal and can strongly influence what ultimately is and is not outsourced. For instance, have the following questions been answered to your satisfaction:

• will the retained assets transfer to the supplier?
• how do you want the supplier to upgrade the assets over the term?
• If investment in upgraded assets is to be kept to a minimum, how does this affect the cost of maintaining progressively ageing assets?
• if you operate in a regulated industry, have you complied with all the requirements of your regulator?
• the Transfer of Undertakings (Protection of Employment) Regulations 1981 (as amended) will apply to almost all outsourcing arrangements, have the costs and the timescales of such compliance been quantified and included?
• do you have any penalties or restrictions in your existing in scope third party agreements that will restrict your ability to outsource?

11) A robust financial model will determine how you want to structure the pricing of the deal and can provide the early warning signals of a deal that carries a higher risk of failure:

• how is the deal priced and what assumptions have the suppliers made?
• why are the assumptions present and what do they translate to?
• can the assumptions be removed by providing more information to the supplier?
• how is change accommodated?

12) Most organisations will experience changes in the underlying volumes (whether by organisational growth or divestiture, or changes in the volumes processed by the outsource supplier), can you look to your contract to provide the answer or are you entering into a relationship that must endure unstructured renegotiations that place too much emphasis on good will?

13) While renegotiation of a long term outsourcing deal, say three years into the Term, might be considered a fact of life in an outsourcing deal, unstructured renegotiation doesn’t have to be. By building flexibility into the deal through, amongst other things, your pricing structure, you can create predictability and provide the basis from which you can accommodate change without major renegotiation of the whole deal. Many outsourcing agreements build in unit pricing against predictable resource units as their base for this reason.

14) The analysis you do in building your financial models will determine not only what resource units are sensible, but also what volume baseline they apply against and how they flex as the volumes change. For example, in mainframe outsourcing, do you negotiate a price per MIP or a price per CPU Minute? Depending upon how you utilise your systems, the two can yield very different results to the bottom line of your annual costs.

15) Pricing structure can also be instrumental in driving the behaviour of a supplier. In one example the services encompassed an IT help-desk and desktop problem resolution, the pricing for the helpdesk was proposed as a per-call price, whereas the desktop support price was a per-user price. Poor service in fixing problems, which result in significant increases in calls to the helpdesk to report, actually increased the compensation due to the supplier. What commercial incentives are there for a supplier to exceed your expectations in such an instance, particularly when it would hit their pocket to do so.

16) The up-front scope and financial analysis is one of the most valuable assets that feeds into the contract and provides the tools to manage the inevitable change that will occur over the life of the deal.

17)The good news is that very few outsourcing agreements fundamentally fail operationally. Where they often fail is in meeting expectations through lack of clarity and understanding between the parties which gives rise to increased costs and performance issues. As we have highlighted, with some good planning and good advice up front, this can be avoided.

The group represents organisations worldwide in information technology and business process outsourcing transactions. Our attorneys have experience with "traditional" outsourcing transactions as well as with strategic joint ventures, limited liability partnerships and other special purpose vehicles.

Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. ^© Copyright 2003 Latham & Watkins. All Rights Reserved.

Latham & Watkins is an international law firm of more than 1,500 attorneys in 21 offices worldwide, including Boston, Brussels, Chicago, Frankfurt, Hamburg, Hong Kong, London, Los Angeles, Milan, Moscow, New Jersey, New York, Northern Virginia, Orange County, Paris, San Diego, San Francisco, Silicon Valley, Singapore, Tokyo, and Washington, D.C.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.