In-Depth

Innovation Outsourcing: Driving Transition Through Partnerships

• 06/01/1999

Outsourcing is not typically thought of as an act of business innovation. In fact, most outsourcing engagements are nearsighted attempts to reduce operational costs through the selective outsourcing of particular business processes. While this approach is perhaps the most common type of outsourcing, a new, more expansive approach is emerging that not only reduces costs but also encourages outside parties to work with their clients in long-term partnerships.

Innovation outsourcing combines the knowledge and expertise of your company’s IT personnel with the operational cost advantages of an outside service provider. The result is a partnership that continually assesses the value and merits of every outsourcing venture.

Selective outsourcing is basically a service relationship that is characterized by predictable performance and cost savings. Changes in the fundamental performance of the service leads to contract re-negotiation. Each time the environment changes, the contract must reflect that change. As a result, selective outsourcing accomplishes a specific task (cost savings) and should not be confused by the vendor or the client as a mechanism for business change.

Innovation outsourcing, on the other hand, helps IT departments establish and promote outsourcing as an integral part of their company’s business. The increased attention puts a direct focus on the relationship between the process outsourced and the degree of business improvement expected.

Cost savings are just one aspect of this equation. Both parties also agree that the outsourced process will be regularly measured against a set of specific business objectives. Instead of simply measuring cost savings, Innovation outsourcing yields other improvements that will further reduce the cost of operation and increase efficiency.

Business planning teaches us that improvements in business efficiency are funded, at least initially, by an infusion of capital. Capital costs then dwindle over time as the efficiencies from the improvement are realized. At some point, new capital improvements are required to start the cycle over again.

The degree to which one function falls and the other climbs is a function of how a business operates. Significant capital investment in a manufacturing organization might bring only modest improvements in business efficiency. However, modest capital investment in information technology might deliver breakthrough improvements in efficiency.

Under selective outsourcing, capital expenditures are applied to maintain cost savings. The advantages created by that cost savings begin to erode over time as the benefits in efficiency diminish. New solutions enter the marketplace, new priorities emerge; in short, the business environment changes. This situation often leads both the customer and the vendor to begin negotiating a new contract. The problem is that selective outsourcing will not lead to new levels of efficiency improvement. Regardless of how many times the contract is renegotiated, the level of efficiency is simply not linked to the contract.

With innovation outsourcing, capital expenditures are built into the agreement and focus on improving process efficiency. Clients understand that while their cost savings may vary, their process efficiency will continually improve. Vendors understand that their competitive edge comes from anticipating and creating new levels of efficiency on behalf of their customers. Only when dramatic change in the client’s business occurs will the innovation outsourcing agreement require adjustment.

Earlier, we noted that selective outsourcing constructs a service relationship to reduce operating costs for a given solution over a given period of time. While the resulting stability is encouraging, the outsourcing vendor is neither expected nor required to introduce new services into the relationship without the direct support of the customer. In fact, any increase in business efficiency is likely to be more a matter of luck than of planning.

If we graph a selective outsourcing engagement it becomes clear that while the cost savings may appear steady (the Vendor Cost line), the real variable lies in the degree of efficiency created. Since the vendor is merely assuming an existing process, efficiency remains at the same level it was prior to outsourcing. When measured against competitive solutions and natural efficiency improvements, the degree of business efficiency actually diminishes over time. Any efficiency gains under these circumstances are a matter of luck, not of design. Only a new capital infusion would create the context for change in business efficiency.

Customers who seek outsourcing engagements, particularly selective ones, are generally interested in cost savings. Initially, the savings seem adequate, but the customer soon notices that changes in the industry or in business direction require more than just cost savings. This recognition usually results in one of two actions. The vendor and customer agree to re-negotiate the contract to update the process (unaware that by continuing with a selective outsourcing engagement, they will face the same problem again) or they decide to terminate the relationship. Termination usually results from a belief on the customer’s part that the vendor has failed to perform. That the customer never linked performance with efficiency is usually forgotten in the excitement.

Innovation outsourcing, on the other hand, requires a link between cost and business efficiency. The vendor and the client establish measurable business objectives that tie directly into the day-to-day efficiency of the outsourced process.

Selective outsourcing agreements fail when clients determine that they can perform a specific task at the same cost level as the vendor. Under innovation outsourcing, the cost level is only half of the equation. Clients must also consider the investment they would have to make to ensure ongoing business efficiency improvements. This added variable, which the outsourcing vendor can leverage across multiple clients, allows a client to take advantage of process improvements that might otherwise be too expensive.

Notice that under innovation outsourcing, the vendor’s costs vary as the vendor invests in improvements on an ongoing basis. Meanwhile, business efficiency declines just as it does under selective outsourcing, but it improves dramatically right after the capital infusion (the improvement). Remember that this is not a one-time process. Both the vendor and the client commit to repeat this cycle of investment/improvement over the life of the agreement.

A key variable in the innovation outsourcing agreement is to establish independent verification of business efficiency. Both parties need to give serious thought to the process that will be measured and the change point at which a new level of efficiency is required. For example, if the vendor is outsourcing a network function, the level of efficiency might be measured as speed of data throughput. Industry publications routinely establish throughput standards for various network types. If both parties agree on reliable sources, industry standards can then be used to establish performance measures.

Over time, technological improvements will change the throughput averages. Using change points expressed as percentage of differences, the vendor knows exactly when the customer expects to see a level of efficiency improvement. For example, "Vendor will maintain throughput on the outsourced network to within 10 percent of the industry stated norm for the applications presently housed on the network." By monitoring the variable, the vendor will know exactly when to make capital investments.

It is also important to state the base case assumptions for a given service. If either party changes the base case, it might become necessary to restart negotiations for that particular part of the service. A good example is e-mail. Over time, simple e-mail applications have become embedded in much more complex groupware applications. These applications are much more extensive and require significantly more network bandwidth to function.

An innovation outsourcing vendor maintaining a basic e-mail solution might require additional capital investment to support a groupware solution with its more complex requirements. In such cases, the vendor and the client can work together to best determine the degree of base investment required by the client.

While industry standard figures represent an independent assessment, many times the client and the vendor agree to use an internally generated measurement. In such cases, the two parties simply agree on how best to generate the value and ensure that its calculation remains consistent over time.

Earlier, we noted that the innovation outsourcing vendor must be a partner, not a vendor. This is particularly true, given the tie to business efficiency. As the innovation vendor accumulates capital for the next level of efficiency, it must tie that efficiency into specific objectives associated with the business as a whole. It would make little sense for the vendor to propose change at a point when the business would prefer stability. Strategic alignment requires a close relationship between parties that is noticeably absent in selective outsourcing engagements.

Strategic alignment is often difficult to manage. While the selective outsourcing vendor has the same goal each and every day, the innovation vendor accepts that customer requirements will change over time. Without adequate knowledge of customer plans, it can be difficult to establish the appropriate capital savings. If changes in client direction are not communicated, the vendor is often left in the undesirable position of playing catch-up.

How can this be avoided? Much has been written on the importance of service in any outsourcing relationship. When relationships are established in the context of a service, that service will remain the basis of the relationship. Both parties will work diligently to ensure that maximum cost savings are wrung from what becomes an increasingly tighter and tighter margin. When relationships are established on the basis of a value, as in business efficiency, both parties have a mutual understanding of the success or failure of the solution as it applies to business, not to simply the degree of cost savings. This understanding becomes the basis for a productive relationship.

What should be outsourced? Selective outsourcing opportunities abound across an organization. From janitorial services to IT outsourcing, selective outsourcing simply reduces your costs in exchange for what is often fundamentally the same service. The vendor enjoys an economy of scale that allows it to leverage its cost structure across multiple customers with similar challenges. A simple test is to evaluate the number of vendors who offer a particular service. The more vendors, the more common the service, and the greater the rationale to evaluate outsourcing.

Conversely, innovation outsourcing is a much more discriminating process. The innovation vendor invests in subject matter experts for a given process. These experts can explain how the process affects your business and what benefits can be anticipated through efficiency improvements.

In outsourcing, you often evaluate your core strengths and determine those non-core items that might best be outsourced. In innovation outsourcing, the unique combination of business expertise and outsourcing should lead you to examine even those processes that might represent a key strength in your organization.

For example, an application that your sales organization relies on might be mission-critical. But the use of a business consultant with outsourcing expertise might not only improve the utility of the application, but also allow you to remove its management from your present network. Removing even mission-critical applications might free up resources to work on even higher priorities. And when business-specific expertise is applied, you reap the benefit in higher degrees of efficiency.

Innovation outsourcing creates unique opportunities for you to leverage specialized business skills in combination with day-to-day management outsourcing. The marriage of these two variables constitutes the key difference that innovation outsourcing provides. With innovation outsourcing, you are not merely outsourcing a process, you are gaining access to specialized business skills.

To some extent, vendors engaged in selective outsourcing are much easier to evaluate than those who maintain innovation engagement expertise. With selective outsourcing, past performance is an excellent predictor of future satisfaction. Vendors who do a good job of controlling costs today will likely do a good job tomorrow.

Innovation outsourcing, on the other hand, requires assessment of not only the vendor’s outsourcing practice, but a willingness to explore that vendor’s current expertise and prospects for long-term expertise in a given business process. At the end of the day, you are asking, "Just how smart are they?" Does your vendor participate actively in industry groups unique to the process? Does it contribute on a regular/ongoing basis to the professional dialogue? How committed is it to hiring and retaining process specialists, individuals whose skills allow both incremental and breakthrough improvement in a particular discipline?

Evaluating an innovation outsourcing vendor requires a commitment to look beyond the performance of the service. Remember that as a partner, you will rely on the vendor to make ongoing and appreciable improvements in your business. If you wouldn’t hire the vendor as a consultant, then you probably shouldn’t hire the vendor as an outsourcer.

Efficiency improvement, whether stated or not, is the real driver in an outsourcing relationship. Without efficiency improvements, a customer’s own employees begin to question the value of the outsourcing engagement. To expect otherwise would ignore the same requirement that every company places on its employees. We demand continuous improvement from our employees, so why should we be surprised when our employees become disappointed if they don’t see improvement from a vendor.

That this is particularly true in selective outsourcing stands to reason. Selective outsourcing vendors seek cost improvements, not efficiency enhancements. Efficiency actually trends downward, and employees begin to explore new ways to improve what they perceive as an outdated and inefficient business process.

Innovation outsourcing demonstrates that by linking efficiency with costs, the opportunity for success is much higher. Both the customer and vendor are motivated by the same set of business-driven variables. It is this linkage that creates a successful and long-term outsourcing relationship.

About the Author:

Matt Kramer is Vice President of Sales and Marketing for Control Data System, Inc.'s (Arden Hills, Minn.) E-Commerce Outsourcing Business. He can be reached at (651) 415-4060, or via e-mail at [email protected].