Structural risk is the result of opportunistic behavior,
according to Aron. The supplier cuts corners or puts
in less than the expected effort. Or the supplier
insists the buyer pay for supplier mistakes.
Here are three ways suppliers do this:
- Deliberate underperformance or shirking
- Poaching or the deliberate misappropriation of
- Opportunistic renegotiation of the contract or
other opportunistic behaviour
Here are some real life examples. In claims
underwriting, a property and casualty insurance
company requires its supplier to check for
25 compliance factors. The supplier, however,
cuts corners and only looks at 18-20 factors.
In ITO, a buyer signs a contract that promises
that the provider's veteran programmers and
systems analysts will work on the project.
But when work commences, the supplier replaces
some of the experienced team members and
sends rookies who cost a lot less.
These are examples of deliberate underperformance.
Here's an example of opportunistic misuse
of information. The supplier's sales staff
gets a bonus if its call center staff signs
up a certain number of new credit card holders.
To boost sales, the supplier's staff offers
the customers a lower APR than the buyer
wants. Now the buyer has a lower yield on
its card portfolio.
An example of opportunistic behavior typically
happens after 18 months into a contract when
the power shifts from the buyer to the supplier.
The supplier suddenly demands a higher price
for the contracted services or insists on
lowering SLA levels, knowing it now has more
bargaining power. "This clearly violates
the spirit of the contract," says the
Source: Ravi Aron
Managing structural risk
Aron says there are four ways to manage structural
- Build transition service clauses into the
contract. Aron suggests adding sunset
clauses to any new contract, which gives the buyer
an additional year of service at the same rate. "Twelve
months buys a company enough time to find another
supplier and transition the process completely," he
- Use multiple suppliers. Switching
suppliers is expensive. The best way to avoid switching
is to not be completely reliant on any one provider.
This guards against lock-in and switching costs. "The
best case examples in supply chain management are
where no manufacturer has just one supplier," he
points out. ITO buyers "are just waking
up to this realization," he adds. In BPO, he
suggests splitting the work by volume and process
- Retain residual capacity. The
goal of outsourcing is to reduce costly in-house
capacity. "But don't lose it entirely," cautions
the professor. "If you have the capacity in
house, it will keep your offshore supplier from playing
games with you," he continues. Retaining strategic
residual capacity also gives buyers the comfort they
can immediately take important tasks back in house
if the supplier starts misbehaving.
Aron says the economics of labor arbitrage make it
difficult for a company in these hard times to keep
expensive labor on its domestic payrolls. But the professor
says it's necessary insurance. He says residual capacity
of 6-12 percent is sufficient in most BPO contracts.
- Monitor and control. The professor
says continuously monitoring what's happening "will
go a long way in stopping the provider from taking
liberties, shirking, or deliberately underperforming.
It's a great deterrent."
Aron says turning a supplier into a business
partner also mitigates this risk. He suggests
buyers add one element to an SLA that is an
intangible composite of many desirable aspects
of the relationship: customer satisfaction. "This
makes the supplier aware it has a mandate beyond
the routine delivery of work. Now it has to
step into the business context of the buyer," he
explains. He says the most successful outsourcing
relationships he has observed have both granular
metrics and customer satisfaction criteria.
The use of customer satisfaction criteria in
addition to SLA-based metrics of output quality
can drive significantly higher quality outcomes.
The buyer tells the provider the buyer's
in-house managers are its customers; periodically
the buyer will survey them, providing customer
satisfaction scores (CSS). The CSS ratings
determine a portion of the payment the buyer
CSS scores cause the provider to "sense and respond" to the business
context of the buyer. The provider understands that there are aspects of the
relationship that the buyer can't easily specify via a system of metrics but
are nevertheless important. It invests in understanding the business context
of the buyer and offers true relationship management.
The contractual governance of the relationship
changes to a "sense and respond" mode
of governance. For business transformation this is necessary; the provider must
go beyond the routine delivery of services. In many BPO and ITO contracts that
Professor Aron has studied over the past seven years in several countries, the
contracts that incorporated CSS scores outperformed those that did not both in
terms of the quality of work from the offshore provider and the buyers' managers'
satisfaction with the offshore service center.
This risk is characterized by a deliberate erosion
of competency in the buyer's organization since it
sent those skills abroad.
The extended organizational form
Aron says the extended organizational form (EOF) "contains
in great measure all three risks." The EOF "bridges
the strengths of both organizations" by letting
the provider's employees report to the buyer's management. "The
buyer's manager treats them as if they were its own
employees," explains Aron. While there is no
direct employee relationship between the buyer and
the provider's employees, this allows the buyer to
divest financial control while retaining operational
The buyer's managers then monitor operations, inspect
the quality after execution, and exert direct managerial
control. "Surprisingly, it also provides operational
benefits to the supplier," says Aron. Over a
period of time the provider's costs fall without
compromising the quality of work.
There is another reason to consider this form of
offshore outsourcing. In the current environment
there is some possibility of legislation that will
discourage companies from offshore outsourcing work.
That legislation may take the form of not allowing
U.S.-based firms to take tax deductions for the operations
of their captive centers offshore. The expense becomes
fully tax deductible if the buyer outsources these
Some firms may fear the loss of control that may
result from outsourcing operations to a third-party
company. This is where the EOF plays a role. It allows
firms to exert operational and strategic control
over their offshore operations without having to
carry these expenses on their balance sheets. The
EOF thus brings together the best features of both
forms of governance: Outsourcing brings the discipline
of the market to the cost of operations while captive
centers give the client firm higher levels of strategic
control. The EOF is subject to the discipline of
the market even while it allows the client to exert
strategic and operational control over the offshore
In these difficult economic times, it provides a
compelling rationale for offshore services. Combining
the EOF with careful use of CSS criteria in contracts
allows buyers to move towards transforming their
offshore service providers into strategic partners.
Companies such as Wipro are taking up initiatives
to address buyers whose objectives not only include
cost savings but also making a strategic business
impact. Wipro's PACE initiative seeks to combine
multiple business objectives including:
- Reduce cost
- Transform the cost structure from fixed to variable
- Earn better yield on infrastructure and asset
- Create a strategic partnership between the two
Lessons from the Outsourcing Journal:
- Knowledge transfer and management, metrics, transition
management, and monitoring help mitigate operational
risks in offshore outsourcing.
- Building transition clauses into the original contract, using
multiple suppliers, monitoring, and retaining residual
capacity reduce structural risk.
- The extended organization form, where the provider's employees
report to the buyer's manager, is a great way to mitigate
operational, structural, and composite risks.
- Wipro set up the Council for Industry Research, comprised of
domain and technology experts from the organization, to address
the needs of customers. It specifically looks at innovative strategies
that will help them gain competitive advantage in the market. The
Council in collaboration with leading academic institutions and
industry bodies studies market trends to equip organizations with
insights that facilitate their IT and business strategies. For
more information on the Research Council visit www.wipro.com/industryresearch
or email firstname.lastname@example.org.
Publish Date: June 2009 outsourcing-offshore.com