Rethinking the Long Term Sourcing Deal

Historically, outsourcing agreements included terms typically lasting five to seven years or even longer – with additional years tacked on as options exercisable only by the customer. But several factors suggest that a customer should think twice and at least consider shorter term deals with its service providers:

The Deteriorating Business Case: At the end of a 5 year deal, the customer is often overpaying for the contracted services. This is true despite what appeared to be a great deal at the outset and various protections built into the agreement, including fixed declining pricing, benchmark rights and pricing reviews. Reasons for this phenomenon include:

Non-labor IT costs decrease more rapidly than the declining price baked into the agreement, especially when measured over 5+ years
Customer needs to change and add services while being fairly captive to the established provider, resulting in above-market pricing for these additional services
“Band aid” additions of new scope during the term of the agreement, leading to sub-optimal solutions and inefficient pricing
Questionable “change order” practices by service providers, such as charging for in-scope services as additional services

Not Quite Ready for IT Evolution: Many customers are not currently positioned or ready to take full advantage of the productivity gains from Cloud solutions, automation, virtualization and other practices such as rationalization. Nor are these customers and their service providers able to answer enough questions and eliminate enough variables and unknowns in order to firmly and smartly price a future-state encompassing these solutions. In these cases, a customer may be better off with a shorter term deal until more optimal solutions are determined and priced.

Deal Investment Costs Less Burdensome: Historically, one of the key rationales for a longer-term deal was for customers to get a better return on the investment costs of a transition and other sunk costs incurred (and passed on) by the service provider. But several recent trends and practices are producing relatively smaller transition costs, such as deals limited to the provision of services only. There is less transition cost and possibly zero capital outlays when no physical move or equipment purchasing is required. Service providers have more experience managing the transition of personnel and knowledge transfer. And customer environments generally are more outsource-ready and require less transition and change than in prior times. These factors often work to minimize what historically had been a larger ROI issue.

Of course, there are downsides to shorter deals.

First, the customer often will get a better price from the service provider in exchange for a longer term deal with a higher total contract value (but, as noted previously, these long term prices are often out-of-market before the end of the term).
Second, the customer may miss the opportunity to shift the longer-term risk of inflation and foreign exchange rates to the service provider.
Last, customers often can exit their longer-term deals early through payment of a reasonably low “termination for convenience” fee. So the customer can maintain some of the long-term protections while still having an option to shorten the deal at a relatively economical price (especially in the out years).