2017 AN EVEREST GROUP VIEWPOINT

The Obscure Choke Points in IT and BPO

Services Contracting
Optimizing TCO Based on Hidden Sarthak Brahma, Vice President
Abhishek Sharma, Vice President
Value Leakages in Contracts Achint Arora, Senior Analyst

Copyright 2017, Everest Global, Inc. All rights reserved.

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Introduction

As a sign of outsourced IT and BPO services maturity, Everest Group has observed
contract benchmarking clauses being diligently invoked at regular intervals. Not
surprisingly, we have observed a corresponding proliferation in benchmark providers
over the years that promise to deliver on evaluating the contracts and helping
optimize them.
However, the focus of most benchmarking / contract review exercises tends to be on
the directly visible levers such as resource unit rate cards and delivery mix
alignment. There are a number of levers that remain hidden and are often ignored,
leading to untapped optimization potential.
This viewpoint outlines some of the common obscure choke points that buyers
need to be aware of, in order to avoid significant value leakage in contracts. These
levers affect the twin pillars of cost and performance, and can help the client achieve
an equitable contract for the outsourced services.

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Factors Causing Value Leakage in Outsourcing Contracts

There are multiple factors causing value leakage in outsourced IT and BPO
contracts, however, they can be collectively grouped into two broad categories:
Direct factors that are commonly targeted in a benchmarking exercise (resource
unit rates and delivery mix)
Obscure factors that are commonly ignored, yet can have a cascading impact on
the contract Total Cost of Ownership (TCO). These include contract terms &
conditions, continuous improvement charter, shadow costing, etc.
Even in the best-laid contracts, we have observed significant value leakage due to
these obscure factors. As shown in Exhibit 1, our recent engagement review
experience points to a higher optimization potential from these hidden factors as
compared with the visible factors.

EXHIBIT 1 REPRESENTATIVE 5-YEAR OUTSOURCING CONTRACT

Contract TCO1
optimization levers
18-24%
Source: Everest Group
5-10%

12-15%
Most commonly
targeted due to high These levers are hidden within the crevices
visibility. Only partial of the solution or contract, yet contribute to a
value capture due to major chunk of the optimization potential. If
limited win win unchecked, they can lead to serious value
potential erosion

As-is Rate card Delivery Contract Continuous Equitable Shadow Optimized

Contract recalibration mix right improvement contract costs Contract
TCO1 alignment sizing charter T&Cs TCO1

DIRECT/VISIBLE LEVERS OBSCURE/HIDDEN LEVERS

Why these factors remain hidden

Contract pricing is a function of the entire underlying solution context. While
negotiating outsourcing contracts, it is typical of procurement teams to focus on the
big-ticket items in the pricing schedule. Therefore, much of the focus is on rates and
factors directly impacting them. A commonly ignored fact is that many non-pricing
parameters indirectly have a significant bearing on the overall price. For example,
the buyer may push for very harsh service level targets and consider it a win, but the
provider will bake in a degree of risk premium that may out-weigh the notional
benefit of those tight targets.
Most contractual mid-tenure benchmarking exercises too fail to highlight these
factors because of a singular focus on resource unit prices. This has led to a majority
of contracts remaining misaligned through their tenure.

1 Total Cost of Ownership

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Typical Sources of these Choke Points

Proposal vs. solution approach

From the perspective of enterprise procurement, a proposal-centric approach is
highly focused on getting the required solution at the lowest possible price, and with
the most favorable terms and conditions. For the service provider, this could mean
using a high offshore mix and junior resources, which may not be suitable for the
buyers long-term objectives.
A solution-centric approach, on the other hand, focuses on the best solution with
equitable terms and conditions at a fair price. The basis for this mindset is to agree
on the solution first, and then optimize pricing and not vice versa. It is not necessary
that the optimal solution will be the cheapest, but this approach leads to the best
long-term value from outsourcing. Therefore, it is imperative for buyers to look for
the best-fit solution while negotiating with the supplier for the most optimal pricing.
As we move towards managed services or managed outcome frameworks, we shift
from a tactical approach towards an outcome-based construct. In the Request For
Proposal (RFP), a client typically highlights the requirements and pain points; it can
then gauge the solution vis-a-vis the ask, rather than focusing only on the provider
inputs.

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Typical Sources of these Choke Points

Lack of contract right sizing

The TCO of a contract is a function of both the Price (P) and the Quantity (Q) of the
resource units consumed. Contract right sizing is very important as it ensures that
the total spend is optimized. Many times, buyers are enticed by very competitive
resource unit pricing proposed by service providers. An inflated effort estimate could
easily negate the benefits of low resource unit price and set the stage for highly
inefficient operations being seen as the required effort for service delivery. Buyers
need to calibrate the effort required through a combination of internal baselining,
and leveraging best-in-class effort ratios for the services in scope.
Another important parameter to consider is the quality of service delivery. For
example, in the application services space, leveraging an excessively lean/junior
team could lead to delayed product launches and higher technical debt. This might
result in higher maintenance costs downstream. Net-net, right-sizing too does not
mean the least effort possible. It means the optimized effort required to achieve
sustainable service delivery.
In all managed services constructs, the PMO fees, transition and transformation
charges, and account management charges are included. While PMO and account
management are part of the governance layer and considered to be hygiene factors,
the transition and transformation stream is critical for the success of a project.
However, each of these elements needs to be sized and priced fairly commensurate
to the actual effort. In many contracts, we have seen an extra loading of effort for the
governance and transition/transformation to make up for visibly competitive rates of
the operational delivery teams.
As another dimension, most mature buyers typically look out for these instances of
cross subsidization to minimize the impact on TCO, but it is surprising that in many
cases such anomalies exist through the contract tenure, leading to ongoing value
leakage. Mature buyers regularly calibrate the effort required with the providers to
reduce effort requirements on a sequential basis, using levers such as pre-configured
templates and automation coverage.
Shadow costing leading to bloated TCO
Calibration of teams for Day 1 service delivery is really important. For example, if the
current delivery is being serviced by 100 FTEs with a majority of team working in-
house, service providers might start their initial delivery with the same estimated FTEs
without adjusting for higher working hours leverage from offshore. Also, many a
times duplicate roles in the ongoing operations can be streamlined by defining a
well- documented RACI for different stakeholders.
Another dimension to shadow costing is the involvement of super users from the
client side, whose role can be taken over by the service provider for a much lesser
cost, thereby allowing client super users to focus on the business aspects of the
service.

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Misaligned productivity charter

Productivity improvement through ongoing continuous efficiency realization is one of
the key benefits of outsourcing to a service provider. However, in many cases the
committed reduction in FTEs and associated costs is kept at the bare minimum and
not in line with contemporary market norms. The motivation for service providers is to
position maximum efficiency through transformation initiatives, which typically have a
gain share clause associated with it.
Buyers need to accurately baseline their initial productivity, and delineate between the
committed continuous improvement and transformational improvement. The year
on year continuous improvement should be mapped to best-in-class metrics and the
FTE impact should be explicitly inked into the contract.
As shown in Exhibit 2, just a 5% difference in cumulative committed FTE reduction
resulted in an optimization potential of US$350,000 over the course of a five-year
contract.

EXHIBIT 2 As-is Benchmark

110
Representative impact of
misaligned productivity
charter in an F&A contract
100
8% Cumulative 13%
Source: Everest Group
FTE Reduction Cumulative
5% FTE
90 Reduction
4%
3% 1% 0%
US$350,000 Cumulative
80
optimization potential due
to productivity alignment

70
Go live End of year End of year End of year End of year End of year
1 2 3 4 5

Inequitable contract T&Cs

Key contract terms and conditions should be equitable and balanced towards both
the buyer and the service provider. Very lenient terms weaken the guardrails for
service quality assurance, but at the same time excessively stringent terms could lead
to avoidable risk premium built into the deal TCO. Some examples of value leakage
typically observed are as follows:
On a recent deal, a one-sided cost of living adjustment (COLA) clause resulted in
an 11% uplift of the fifth year ACV as compared with the best-practice benchmark
Overly stringent contract tenets (warranty, service credit regime, etc.) lead to
unnecessarily high risk premiums
Strict SLA targets for the entire scope lead to the supplier adding significant
operational contingency margin and a resulting inflated TCO
Unnecessary service-level metrics that remain in the contract long past their
meaningful use

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Conclusion

In the context of outsourced services contracting, there are a number of obscure

factors that lead to value erosion through the tenure of the contract. A singular focus
on price / resource unit rates is more often than not a breeding ground for these
choke points to surface.
Buyers can leverage several mechanisms to avoid the negative impact of these choke
points. Prime among these are:
Initial calibration of productivity baselines, effort requirements, and required SLA
targets to support negotiations at the time of contract signing
An objective mid-tenure benchmarking exercise that focuses not just on pricing,
but also key cogs such as solution review, contract T&Cs review, and
delivery/performance metrics review
Concerted efforts to implement such mechanisms position buyers to achieve the full
potential of an outsourcing relationship. Ensuring efficient contracting but also
realizing any benefit through value-adds such as featured automation or innovation
should be truly accounted. Contracts can be fraught with prevalence of choke points
that can compromise the cost and performance.

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About Everest Group

Everest Group is a consulting and research firm focused on strategic IT, business
services, and sourcing. We are trusted advisors to senior executives of leading
enterprises, providers, and investors. Our firm helps clients improve operational and
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well-informed decisions that deliver high-impact results and achieve sustained value.
Our insight and guidance empowers clients to improve organizational efficiency,
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integration of deep sourcing knowledge, problem-solving skills and original research.
Details and in-depth content are available at www.everestgrp.com.

For more information about Everest Group, please contact:

+1-214-451-3000
info@everestgrp.com

For more information about this topic please contact the author(s):

Sarthak Brahma, Vice President

sarthak.brahma@everestgrp.com

Abhishek Sharma, Vice President

abhishek.sharma@everestgrp.com

Achint Arora, Senior Analyst

achint.arora@everestgrp.com

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