Small Outsourcing Deals Pose Their Own Big Risks

Driven by needs such as lower costs or specialist expertise, more and more BPO and IT outsourcing customers are turning to smaller contracts with a larger number of providers. According to the 2011 ISG TPI Index, the number of contracts in the $25 million to $99 million range grew considerably in the past year compared to those worth $100 million and more.

Ah, but smaller deals don’t necessarily mean smaller worries for clients.

In fact, switching providers can actually lead to huge difficulties. Read on as two outsourcing experts examine why when it comes to the size and scope of outsourcing projects, bigger often really is better.

BPO providers are following the lead of ITO providers by deflating their costs to attract customers with low price tags, according to Robert Morgan, director of Burnt Oak Partners, a UK-based outsourcing advisory firm. But Morgan warns low upfront costs can mask hidden expenses down the road if the customer decides the services are not up to par.

“The trend is definitely toward both smaller scope and shorter-term contracts in BPO,” says Morgan. “This follows the established trend in IT outsourcing. However, in first-time contracts, this means the supplier having to ask for one-time transformation costs (such as standardization, virtualization, and offshoring) separate from the main contract. We see these costs artificially lowered to secure the business, and subsequently do not believe that some contracts can be profitable over the contract-term. This is particularly true of the Indian offshore providers.”

Small Deals Put Viability into Question

At a micro level, Morgan says the longer-term implication of this trend is both IT outsourcing and BPO is that suppliers will put little effort into these accounts and performance will suffer, as they set an artificially low price simply to obtain a large number of customers, but at a macro level, too many unprofitable contracts and poor resultant performance will lead to supplier consolidation.

“The client should therefore understand the added risk of using a small- to mid-sized supplier (who is more likely to lowball their prices simply to grow their customer base) as opposed to a top-tier player (who has an established reputation to protect),” advises Morgan. He also recommends outsourcing buyers perform rigorous research before entering any deal of any scale, and possibly seek third-party help in doing so.

“Everything is in the preparation and negotiation,” says Morgan. “Nobody should sign up to things they cannot quantify. External specialized legal or consultancy will never allow such rip-off scenarios. The secret is preparation, preparation, preparation. Ask the question, get the answer in writing and employ a professional, and you will not get any nasty surprises. It is really that simple.”

What Makes Small Deals Risky

Chris Herman, a senior consultant with Swingtide, a consulting firm specializing in CIO business issues, echoes many of Morgan’s observations, particularly when it comes to the high cost of separating from a small-scale outsourcing deal.

“On the ITO side, there has been a trend toward smaller deals, but it hasn’t been well understood,” says Herman. “At a point the scale becomes problematic. A contract size below $10 million is enough to cause problems. The one-time costs of exiting the deal proportionate to benefits of changing deal become so high they’re prohibitive. You get trapped and have to figure out how to make do with a contract you don’t like.”

Herman says these one-time costs can include, but are not limited to, termination fees, knowledge transfer fees, software license fees, consent fees, service overlap fees, application remediation to move to a new platform, and hiring/start-up costs for new staff. He also advises these one-time costs are “never less than seven figures.”

On the BPO side, Herman said there is a similar dynamic at work, but with less severe consequences. “Business processes can be much smaller in scale than IT processes and don’t carry the same freight and associated infrastructure and complexity as ITO,” he says. “You can do BPO on a much smaller scale.

However, what Herman terms a natural tendency for businesses to explore BPO deals so small they are at the fringes of the “point of diminishing returns” still creates issues. “The challenge becomes governance,” he says. “A company wants to sew together best-of-breed outsourced processes for specific problems, but can no longer manage all the different BPO suppliers with their existing staff. People lack the skill set for that type of complex governance of multiple relationships.”