In Outsourcing, Less Expensive May Not Be Cheaper

My Mother always told me that cheaper is not a statement about price but rather a comment about quality. In the outsourcing world, cheaper has always been measured as lower unit rates, whether for application developers (dollars per FTE) or computing power (dollars per box or CPU minute) or for a broad range of BPO services (price per employee per month (PEPM) or dollars per claim). There are many advantages to the fixed unit rate form of contracting that has developed in the outsourcing industry. It provides a pricing mechanism that is easy to understand and fairly (though not completely) flexible to adjust for changing volumes and business circumstances. It also puts an incentive on efficient supplier operations and provides a convenient metric for benchmarking against other suppliers or other alternatives.

However, at least in the IT arena, it does not provide much of an incentive for the efficient use of the resources being consumed. In most cases, the supplier asks the customer how many “widgets” it has, and develops both a unit price and a projected price over the contract term based on the number of customer-identified units. So long as suppliers were able to offer year-over-year reductions in unit prices and unit prices materially lower than a potential customer’s comparable unit costs, everyone was satisfied. Moves to offshore or remote support locations (so-called labor arbitrage) have been a key driver over the last ten years in producing constantly lower unit prices. Similarly, supplier investments in tools, enhanced training, common processes and other forms of forms of standardization have continued to drive supplier unit costs lower.

Within the last two years, we have observed a leveling off in the rate of supplier-offered unit rate reductions. It appears, at least for the near term, that the rate of productivity increases reflected in lower IT unit rates is not as great in years past. This is best seen in a number of very recent proposed IT outsourcing transactions where the supplier’s unit price is not much less (or not lower at all) than the internal customer’s cost to deliver a comparable service. But, even in these cases, customer IT management, as well as a customer’s business management, still view the total cost of providing IT services as much too high. How can this be? How is it that a customer’s unit cost to deliver a service is not much greater than the outsourcer’s price to provide the comparable service, but all users of the IT service still view the cost of the service as too high?

Total price has always been a function of price times quantity; what the industry often calls “P x Q.” If the unit price component of the customer and outsource supplier are comparable, then the only culprit for too high a cost must be the quantity of widgets being used to deliver the service. And this, in fact, is what we are seeing on an increasing number of recent proposed IT outsourcing transactions. It is not that the customer’s unit costs are too high, but rather that the customer is using too many resources (widgets) to deliver the service. The implications of this for the outsourcing market are straight-forward but profound: suppliers need to start competing not only on unit price but also on their abilities to deliver the service with less resources than those used by the customer.

Unfortunately, suppliers have in many cases either been unwilling or unable to rise to the challenge and offer solutions focused on a reduced quantity of resources and not merely a lower unit price. It may be that suppliers are not providing their pursuit teams with people who have the right skill sets to craft solutions that reduce resource usage. Or it may be that suppliers are unwilling to take the risks implicit in a transaction that requires not just low unit costs but lower resource usage. In many cases achieving lower resource usage likely involves commitments or actions from the customer and it always has been risky for a supplier to assume that the customer will deliver on its commitments regardless of what the contract may state. In any event, the road forward for both customers and suppliers is clear: there is an immediate need for a substantially increased focus on reducing resource usage as part of structuring outsourcing relationships. In the future, real cost reductions will come from IT operations that deploy fewer resources to deliver services and not from organizations that have low unit costs but high resource usage. So, in these cases, less expensive IT service deliver depends not on cheaper prices but on more efficient and more effective use of less resources.