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Five Important Issues When You Renew Your Outsourcing Contract


The total outsourcing market is expected to reach $250 billion in 2013. That’s a lot of contracts! At some point, they all need to be renewed. If this is your second time around on an outsourcing contract, you are a bit wiser than you were in contract number one! We all learn something from our outsourcing experiences, and when we enter into a new contract, we all have ideas about how we can have a better and more productive agreement. For most outsourcing clients, you only got quite a bit less than you wanted to out of the first contract. After all, the industry standard is that half of all outsourcing programs fail. However, if your program survived the first contract, now you have a chance to make improvements and possibly do a better than expected. One of the biggest potential areas for improvement is in cost. So, let’s start there and find how we can better control the financial risk on your contract!

When you started your first contract, you probably had a very simple model of operational costs, a worker’s salary and not much more than that. If you work in a large corporation, you know that it is often very difficult to get accurate information. It may not even be possible to figure out real costs, especially if your firm has a formula to allocate costs. For example, look at the costs of benefits. Your firm may have 3 or 4 different plans, and a different cost for each plan depending on the number of family members for each employee. Regulations in different states require different insurance plans. When you analyze your operations to understand the cost of these benefits, at best you may only be able to get a very rough estimate such as, “ 5% of your payroll.”

Other costs, such as IT services, are even more difficult to allocate. Your IT department may have mainframe services, Unix servers, charges for email, laptop support fees, etc. Because services, space and managers overlap, and because not every service is directly allocated to the people who use them, these allocations are often arbitrary. PC users may be bearing the cost of equipment for other computer services, not because they are using these services, but because it makes sense to an administrator to charge out costs this way. Likewise, there are many corporate services that are charged per employee, regardless of whether you use the service or not. However, with outsourcing, you get charged directly. An outsourcer cannot charge you unless you agreed to be charged.

When you set up your contract, you probably spent a lot of time negotiating salaries or hourly fees. By now you’re learned that as important as the hourly fees are, they are not the endpoint for determining cost… the are just the starting point. Now that you have some outsourcing expertise under your belt, you’re ready to learn about the next level of cost factors. With that, let’s jump right in and review the top five costs issues for your next outsourcing contract!

PAY RATES OR COSTS: For your first contract, you probably chose to pay an “all in” hourly rate. Just paying a rate per hour, and no other expenses, is a safe bet. If something goes wrong, the risk is all on the vendor’s side. But you have probably also found that there can be subtly negative effects from a fixed rate. If the rate is wrong… because there are unplanned costs… it is very difficult to pay the vendor for additional costs, even if you agree that the cost is legitimate. The vendor will be very reluctant to spend the next dollar to improve your program, because that will reduce profitability; the vendor-side manager of your program is likely to be compensated based on the profitability of the program. On the client side, you are reluctant to ask your firm to pay more because a fixed rate contract rarely provides a mechanism for higher pay; if you want to pay more, you probably need to go outside of the contract to provide that payment, which is not likely to be well received by administrative departments (accounting, Procurement, and other oversight groups).

If you've had problems with your 1st contract… did your problems have to do with the inflexibility of a fixed rate contract? Now that you have a better idea of what works and what doesn't in your particular program(s), for the next stage in developing your program do you need the ability to experiment and change variables in order to improve your results? If so, consider if you should use a different form of contract, that allows you to pay directly for or reward specific results.

MISSING BENEFITS: When you started your first contract, you analyzed your own costs. You probably left out a few important costs, such as: rent, power, facility maintenance, furniture, etc. These are the sorts of costs that are often allocated, without a direct charge. Some of these costs, such as space, can be extremely expensive. A typical cubicle in a major city can cost $10,000 to $15,000 annually. Saving that money could be a significant benefit. However, space costs don’t necessarily go away when the positions are outsourced. If you outsource your workers, but they stay on-site, then regardless of who is paying them the costs remain. Fair enough. However, if you reduce your headcount by moving workers to some other location, what happens to your space costs? For example, if you outsourced secretarial work, then you have freed up a number of seats, but these seats may be scattered around the floor (or floors). Your department may no longer be billed for those positions, but the firm still carries the cost since these scattered seats cannot be leased out. Unless someone else carries the cost of the lease, the cost remains.

However, you’re now renewing your outsourcing contract. That means that three to five years have passed since the start of your program. Typically, a commercial lease is for between three and five years. If your firm has multiple locations, even if your lease is not up, others leases around the firm may be due. Speak with your procurement and facilities departments. Have you accounted for the space costs? If you continue to outsource, or if you want to bring the project back in-house, are you fully accounting for the space costs? What about other employment costs (health insurance, employment tax, etc.). If you haven’t previously accounted for these costs, but you add them in now… how does that affect the results of your program?

MISSING COSTS: The other side of the coin is that not all costs are always accounted for. If you contracted for a dedicated service, you have learned that you need to visit and audit your facility, in order to ensure that your work is being performed in accordance with the contract terms. If you contracted for a “Cloud” service, you may not feel that a visit is needed. If it is truly a computer based service, where your vendor in turn uses services from other vendors and no one truly knows where your data physically resides, a site visit would not be useful. If the service physically resides in a specific location, you should visit the site. See if there are physical controls, such as a gates, guards and locked doors. Is the building in good physical condition? Inside of the building: are there video cameras, are the facilities clean; do they have fire extinguishers, etc. These are only the most basic features, but unless you see these conditions for yourself, you don’t know if your expectations are being met. When the vendor is in your city, visiting costs are negligible. But when you offshore, you may need to set aside a considerable budget for site visits.

A far more extensive cost that is often forgotten is the cost of termination. If your program requires the termination of staff, you need to know what sort of payments you will make to your staff. In the UK, there is a law called TUPE that determines exactly what you need to pay. In the US, every HR department will have a different way to calculate what you pay. You need to talk to your HR department to estimate the cost. The longer an employee is with you, the lager the payment at termination. In some cases, the cost of termination should be counted when determining the benefits of an outsourcing program. In other cases, it should not. Because these payments can be very high, it is critical that you know what termination costs are, and if they should be part of the benefit equation.

FOREIGN EXCHANGE: When you create an offshore outsourcing program, there is a little understood additional risk. Your contract probably states that you will pay in your local currency, for example, Dollars if you are in the US. Let’s say that your offshore program is in India, and is run by a vendor that is largely based in India. Then most of the costs for your vendor will be paid in Rupees, the currency of India. For reasons that have nothing to do with your vendor or your program, both the Dollar and the Rupee will change in value, perhaps by a large amount. In the last five years, the exchange rate between the two currencies has varied from 39 to 56 Rupees to the dollar. That’s a difference of 45%. Even if your program had absolutely no inflation of increase currencies could have increased or decreased your costs by 45%. Foreign exchange rates are almost a random factor, given all the factors that can change the value of two different currencies. Even with perfect cost management, the exchange rate could dominate your cost structure. If you have an offshore program, foreign exchange is a factor you must account for, especially when your contract is renewed. How does your next contract mitigate, or at least account for, a big swing in exchange rates?

STAFF ATTRITION: All outsourcing programs can be adversely affected by attrition. The farther away you outsource, the greater the effect of attrition. Why? Because, the closer you are to the “local market” for the skills you are outsourcing, the easier it is to hire individuals with the skills you need… albeit at a higher cost than training your own staff. When you move farther away, especially if you outsource to an offshore location, you may not have access to individuals with the skills you need in the labor market you are building your service. Since you (or your vendor) has to train and educate new employees, every employee who leaves may represent a loss of years of staff development. The reasons why staff leave is either pay or promotional opportunities. If you want to keep staff, creating a bonus pool and even going to the vendor and personally handing out bonuses (or you might call them awards, or fellowships, or something else), can have a tremendous impact on reducing attrition. Because most clients largely ignore offshore staff, they do not feel connected to the account and leave. Personal attention, traveling to the work site, having “events” with the workers, all have a highly positive effect on productivity and retention. Did you have a turnover problem during the 1st contract? Give some thought to award systems, and see that your contract has provisions for authorizing these awards.

There are many costs associated with managing a high quality outsourcing program. Costs and benefits are not fully understood when you first set up your program, which is perfectly fine. When you first set up your service internally, it undoubtedly grew and evolved over a long period of time with mistakes and problems eventually worked out of the system. Likewise, when you then take that service and outsource it to a vendor, you should not expect that your program will run perfectly on day one. Rather, your first contract is when you work out the bugs and get a reasonably working program off the ground. Your next contract is when you make use of what you have learned and build a program that is better than the 1st year, and may be a significant departure… in some way… from the way that you ran things as an in-house program. Now that it is time to renew your contract, are you ready to fix previous problems and move your program to a higher level?

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