How outcome-based outsourcing can make BPO deals a win-win situation

Many business process outsourcing (BPO) deals fail to deliver on strategic objectives, but there are ways to close the gap and achieve expected values.

In brief

• How can business process outsourcing (BPO) lead to a successful, value-generating partnership?
• What does the sourcing business model have to do with it?

What do traditional outsourcing deals usually achieve? Most people would agree that outsourcing to a supplier who is an expert in the outsourced services can yield benefits such as lower costs and higher service levels. A good supplier will likely even lower your risks through strong process controls and deliver on standardization goals.

More and more organizations turning to Business Process Outsourcing (BPO) are seeking more strategic relationships with their suppliers which can help them transcend a transactional approach to achieving business outcomes. Driving innovation, achieving digitalization goals, or enhancing transparency and operational quality are all examples of potential outcomes. However, making the shift to an outcome-based approach requires a very different collaboration with your supplier because achieving business outcomes almost always requires cross-functional and end-to-end coordination.

Unfortunately – and all too often – organizations try to make the shift to an outcome-based approach and fail. One reason for this is that buying organizations do not understand an outcome-based deal requires a different approach to working with the supplier. It is easy to say you want an outcome-based outsourcing deal, but then fail to architect the deal in order to achieve outcomes. For example, buyers may say they want the supplier to achieve `x` level of digitalization with the use of the newest technology, but then do not equip the supplier with the means or trust to deliver. Other common traps include:

• Creating a detailed statement of work specifications for the supplier versus a more flexible approach to define the scope of work that allows the supplier to challenge the status quo or to drive innovation
• Relying on conventional Service Level Agreements (SLA) tied to the supplier’s output versus a business outcome
• Using a transactional or output-based economic model rather than transitioning to an outcome-based economic model
• Using a shadow organization that manages – or even micromanages – the supplier versus investing in governance mechanisms that promote collaboration and transparency for the buyer and supplier to work together to achieve business outcomes

These flaws, known as sourcing business model mismatch, often result in disappointment because the supplier fails to deliver on the promise of business outcomes.

But is it the supplier’s fault? We argue that most of the time, it is not. Rather, the root cause is a poorly architected deal.

Take, for example, a company that wanted their supplier to increase operational efficiency through standardization and automation but paid their supplier at a transactional rate per FTE. The mismatch in the economic model created a perverse incentive for the supplier: the more they increased efficiency, the fewer FTEs were required, meaning less revenue and profit for the supplier. A win for the buyer was a loss for the supplier. What can often be observed in the market is that companies, not seeing the initial deal objectives met, will re-negotiate almost identical deals with the same or a similar supplier, expecting better results, in practice doing the same things over and over again.

So how can you transition to an outcome-based business model? The first step is understanding whether an outcome-based business model is right for your situation. 

Different models for different situations

A typical buying organization has hundreds, if not thousands of suppliers. For example, P&G has 80,000 suppliers. Not all should operate under a highly strategic outcome-based business model. The University of Tennessee’s work on Sourcing Business Model theory indicates that there are four viable sourcing business models for outsourcing deals.[1]

Approved Provider

• Services are procured from suppliers that meet certain predefined performance or selection criteria
• The economic relationship is based on transactions, e.g., the number of invoices handled, tickets closed, hours spent
• Providers are selected primarily based on price but can be added to the approved vendor list based on other criteria such as geography
• The model makes it easy for business users to engage a supplier for commodity-type services by providing a pool of pre-approved suppliers

Since most BPO deals span several years and require investments to enable system access/integration, the Approved Provider model should only be used for highly transactional commodity-type services. As such, organizations seeking value beyond basic transactional delivery or significant supplier integration in their operations should not use an Approved Provider model.

Preferred Provider

• Services are purchased from pre-approved suppliers that, in addition to meeting certain performance or selection criteria, are also able to add differentiated incremental value to the business
• Promotes a collaborative relationship through longer-term and/or renewable contracts
• Similar to the Approved Supplier model, the economic model is transaction-based

A properly structured Preferred Provider model can be successful in finding a supplier to provide value-added services. However, buyers need to be cautious as the transactional economic model can create perverse incentives to maximize transactions to increase revenue, without creating value.

Performance-based agreements (Managed Services Model)

• Generally, a longer-term agreement – typically three to five years and sometimes even longer
• Shift to a more strategic relationship with the supplier being selected to help drive improvements against Service Level Agreements or to achieve cost saving targets (glide path)
• Uses an output-based economic model that typically links supplier incentives and/or penalties for hitting or missing performance and/or glide path targets

Performance-based agreements are becoming much more common in BPO deals. A properly structured performance-based agreement shifts the burden of performance to the supplier. In exchange, the buyer recognizes the supplier as an expert and gives the supplier the autonomy they need to make improvements within their control. Performance-based agreements can work exceptionally well when the supplier is the expert, existing processes are not optimized, and volumes are fairly stable.

Outcome-based model

• Outcome-based deals are typically long-term agreements – similar to performance-based agreements
• Changes metrics from supplier-controlled outputs (SLAs) to business outcome success factors across divisions
• Transition to an outcome-based economic model with shared risk and shared reward
• Demands a high degree of trust and collaboration as the parties work together across function silos and company silos to achieve mutual success with respect to the business outcomes

A well-structured outcome-based deal prevents the Watermelon Scorecard and scope creep as it aligns interests with shared risk/shared reward. In addition, the parties transparently work together to mitigate and manage risk versus shifting risk to each other, thus promoting collaborative and win-win behaviors.

In the example of the Procure-to-Pay BPO deal discussed above with an SLA for processing invoices, an outcome-based deal would look at the end-to-end process and measure the total days to pay. This boundary-spanning shift prevents the possibility of the supplier saying: “We did our part – it’s not our fault you can’t do yours”. The shared risk/reward nature of the pricing model creates an inherent economic incentive for the buyer and supplier to work together to achieve a joint goal – collaborating to uncover the root causes and drive systemic improvements in the process rather than just increasing performance within the supplier’s control.

In order to be successful, an outcome-based model requires a highly collaborative approach based on trust and a true win-win partnership.

Sourcing business model assessment

The University of Tennessee (UT) has been researching performance-based and outcome-based outsourcing agreements for almost two decades. Their findings? Organizations that simply transition to an outcome-based economic model without also leveraging relational contracting principles almost always end up in a frustrating situation. Therefore, UT researchers suggest that organizations perform a sourcing business model assessment to ensure they pick the appropriate sourcing business model, and architect their deal to align with both the appropriate relationship model and economic model.

A sourcing business model assessment considers two primary factors: the most appropriate relationship model and the most appropriate economic model.

There are three types each of relationship models and economic models.

Typically, a four-hour working session is conducted with a client at the start of their sourcing process. The workshop involves key stakeholders working through a sourcing business model mapping toolkit where team members discuss 25 business attributes. Based on their answers for each business attribute, a map is created that points the company to the most appropriate sourcing business model for their situation.

Figure 1 below shows the results of a sourcing business model mapping exercise from a large Nordic company operating under an Approved Provider model (transactional contract with a transaction-based economic model). Going through the 25 attributes, the team determined the most appropriate approach was a Vested outcome-based business model (relational contract with outcome-based economic model). 

A common issue with outsourcing deals is that they are operating with a sourcing business model mismatch. This happens when the company is using a combination of relationship and economic models that does not align. For example, a common mistake for a performance-based model is that parties are using an output-based economic model but fail to make the shift to a relational contracting model. When this happens, the supplier can be handcuffed because the parties are operating in a more arms-length contractual environment rather than a relational contract that promotes collaboration through relational contracting constructs such as a formal shared vision, guiding principles and relational governance mechanisms.

Multiple observations show sourcing business model mismatch happens due to the power-based mindset of buying organizations. Take, for example, a company wanting to shift to an outcome-based model. The company says they want an outcome-based deal – but they don’t realize making the shift requires aligning both the relationship model and the economic model. Companies that only shift to an outcome-based economic model are unlikely to get the results they want because they are not creating the essential relational constructs demanded by an outcome-based model.

The Vested methodology for creating outcome-based deals

The University of Tennessee’s research led to the development of a methodology for creating outcome-based business models. The UT researchers coined the methodology ‘Vested outsourcing’ – or Vested for short. Parties using the Vested methodology co-create a relational contract based on mutually defined desired outcomes. The parties then align a win-win outcome-based economic model where the parties operate under a win-win pricing model with incentives for the parties to collaborate to create – and share – value.

The Vested methodology combines five rules (see Figure 2) to create a formal relational contract with an outcome-based economic model. These are followed sequentially when defining the contract, which is a collaborative effort between the buyer and the supplier. In other words, there is no predefined statement of work that the supplier submits a proposal or price for – the contract is co-created.

What are the benefits?

Kate Vitasek, the lead researcher behind UT’s work– describes Vested as enabling buyers and suppliers to have a What’s-in-it-for-We (WIIFWe) mindset and contract: “The Vested methodology helps parties make the shift from saying outcome-based to truly achieving a fair and balanced WIN-WIN deal. We’ve been tracking organizations that make the shift using the Vested methodology and the results are spectacular. When shared value principles take hold in a relationship and companies properly architect their outsourcing deal, it enables the parties to unlock innovation and value creation opportunities. In short, the parties become vested in each other’s success.”

EY – a leading Vested Center of Excellence – has been helping dozens of companies across the globe make the shift to outcome-based business models using the Vested methodology for more than a decade. The companies’ results are almost always very impressive, with most Vested deals having delivered on desired outcomes within one to two years, delivering value to both parties that was never expected before. With the most Certified Deal Architects out of any Vested Center of Excellence, EY has advised companies on how to move towards a true win-win partnership in industries ranging from BPO, facilities management/real estate to contract manufacturing and logistics.

EY performs an annual study on the implemented Vested deals, and the results indicate there are other significant benefits to the Vested methodology.

• 100% say their pricing model (partially) drives the right behaviors
• 95% say their partnership is striving towards achieving desired outcomes
• 95% have implemented transformation or innovation
• 95% have achieved a “What’s In It For We” culture between the buyer and supplier
• 95% say the governance structure works better than a traditional contract
• 95% say their contract has attracted the A-team from the supplier compared to a traditional contract

Some highlights from specific deals are presented below in Figure 3.

The concept of shifting to an outcome-based model is full of hype. On the surface, this is a good thing because outcome-based outsourcing deals can drive innovation and value creation for both buyers and suppliers. But all too often, people say ‘outcomes’ but fail to create a true outcome-based agreement.

Making the shift

As mentioned previously, the road to an outcome-based outsourcing deal should start with soul searching using a sourcing business model assessment to determine if an outcome-based agreement is indeed the most appropriate model for your situation. You then need to decide between two distinct approaches, either a ‘flip-the-deal’ process or a request for partner process. They both integrate the Vested methodology so you can feel confident that you will be architecting your deal correctly. The main difference is that a flip-the-deal process is designed for an existing buyer-supplier relationship while a request for partner process is used when a buying organization either does not know which of its suppliers would be appropriate to transition to an outcome-based deal or is not working with an existing supplier.

Figure 4 summarizes the differences and how they compare to a traditional competitive tender process.

According to UT’s Kate Vitasek, the majority of organizations making the shift to outcome-based agreements using the Vested methodology use a flip-the-deal process. The process helps existing buyer-supplier relationships make the shift to a successful outcome-based outsourcing agreement.

When it comes to the second or third generation of a deal with the same supplier, many companies find there is no juice left in the existing model and are open to a true partnership. And if the buyer started a bidding process, they feel they would most likely pick the same incumbent supplier either due to known capabilities, good existing performance, or high levels of trust.

The first step in using a flip-the-deal process is to perform a deal review of the current agreement. This takes a baseline of the existing relationship including identifying where the existing sourcing business model may have mismatches (e.g., you may be operating in an approved provider model now and the review will show you exactly where you will need to change metrics, work scope, pricing model, governance and even behaviors). A key part of the deal review is doing a compatibility and trust assessment to identify systemic gaps in compatibility and trust that may be causing a what’s-in-it-for-me (WIIFMe) vs a what’s-in-it-for-we (WIIFWe) mindset.

Once the buyer and supplier understand the current situation and gaps, the parties work together to co-create their Vested agreement, going through the Vested Five Rules. Once the parties have defined their new outcome-based sourcing business model, they jointly transition to work under the new model.

Request for partner process

A request for partner helps organizations make a Vested agreement when they are uncertain about which supplier they should work with. Once the buying company has developed its strategy, it issues an RFI followed by the request for partner process. A key part of the request for partner process is to evaluate potential partners for strategic fit and compatibility. This means determining which suppliers are best suited to enter an outcome-based partnership with. The criteria for finding a new partner will vary according to the desired outcomes, but fundamentally should include such things as compatibility and trust between parties, delivery capacity and solution, and essentials like reputation, financial stability, and good references.

Do you have more questions?

Please contact EY’s Outsourcing Advisory practice – a Vested Center of Excellence – to work through the 4-hour sourcing business model assessment workshop or have us perform a more comprehensive deal review which highlights detailed gaps relating to the shift to an outcome-based outsourcing deal.

There is no harm in at least exploring your options. A sourcing business model assessment is easy and requires little time and effort. And if you decide to start the Vested journey, you can always stop the process down the road. The process is designed so organizations can stop the process after each of the Five Rules if they are not seeing the potential value of making the shift.

One thing is for sure: there should be no limit to the upsides of a properly structured outcome-based deal. The win-win nature of a well-structured outcome-based agreement creates significant incentives for suppliers to bring their best resources to the table – which is what every value-focused BPO deal needs. Using the Vested methodology helps the hype of outcome-based deals become a reality.