Big Deals, Big Savings, Big Problems

Large-scale outsourcing deals promise big savings, but they fail half the time. Here's how to make them work for you.

A CISR-CIO STUDY

Part 3 of a three-part series about outsourcing strategies and success models, defined in original research by MIT's Centre for Information Systems Research and CIO (US).

Part 1, "Simple and Successful Outsourcing", appeared in the November 2005 issue of CIO and examined the transaction relationship, in which an outsourcer executes a well-defined, repeatable process for a client.

Part 2, "Offshore Allies" appeared in the December/January issue and reported on the co-sourcing alliance, in which client and vendor share management responsibility for a project's success.

This final instalment looks at the strategic partnership, in which an outsourcer takes on responsibilities for a bundle of its client's operational services.

READER ROI

• Why "strategic partnership" outsourcing is riskier than other types of outsourcing
• How CIOs should closely manage their large-scale outsourcing deals
• Why day-to-day interactions are more important for success than contract stipulations

When Campbell Soup CIO Doreen Wright WAS trying to cut costs to fund a multimillion-dollar global investment in SAP, she found help from what many might view as an unlikely ally - her outsourcing vendor. Without being asked, IBM re-examined the outsourcing contract and identified several million in services it was providing that could be cut with minimal pain to Campbell. Recognizing the financial hurt that move might cause her partner, Wright took the sting out of it by working with IBM to identify new outsourcing services (which, by the way, would also further reduce her IT operating budget) and awarded the vendor several other projects in the following months. "They were very forward-thinking, and there was a tremendous amount of teamwork involved," says Wright. Bottom line: Campbell cut its IT costs and was able to go ahead with the SAP project, while IBM actually saw its revenue increase.

The Campbell-IBM relationship is an example of what Jeanne Ross, principal research scientist at MIT's Centre for Information Systems Research (CISR), calls "strategic partnership" outsourcing, in which a single outsourcer takes on responsibilities for a big bundle of IT services. These contracts include everything from mainframe operations and network management to application support and help desk services. The success of strategic partnerships depends on mutual benefit. CIOs set up these large, long-term deals to cut costs, access variable capacity and focus on their own core competencies. Vendors sign on not only to make money by taking advantage of their internal best practices and economies of scale but also in the hopes of becoming a first-choice provider for the client and moving up the value chain of IT services.

When strategic relationships are good, they're very good. Client and vendor work together, and the benefits accrue to both parties' bottom lines. But when they are bad, they're awful. Client and vendor can develop an adversarial relationship and become embroiled in bitter contract battles. In fact, half of all strategic partnerships fail, according to a study by CISR and CIO (US).

The two other outsourcing models identified in the research have higher success rates because they're simpler for both parties. Transaction relationships, in which an outsourcer performs a well-defined process that has clear business rules, work out for CIOs 90 percent of the time, while co-sourcing alliances, in which client and vendor jointly manage projects, are successful for the client in 63 percent of cases, according to the CISR-CIO research.

Evidence of the difficulties inherent in strategic partnerships has been seemingly everywhere lately. JPMorgan Chase pulled the plug early on its $US5 billion outsourcing contract with IBM in September 2004 and brought the work back in-house (see "Backsourcing Pain", CIO October 2005). Dow Chemical prematurely cancelled its $US1.4 billion deal with EDS in July 2004 and brought in IBM to start over. Even GM, which had the most long-lasting of any outsourcing relationship - its involvement with EDS dates back to 1986 - is backing off its strategic partnership and introducing more vendors into the mix, in a multisourced model.

The difficulty with strategic partnerships lies in their complexity. "Making these deals work is very difficult because the magnitude of the challenge is far greater," says Jeff Kaplan, senior consultant with the Cutter Consortium's Sourcing and Vendor Relationships Advisory Service and the managing director of ThinkStrategies. "The outsourcer is assuming a broader scope of responsibilities across the enterprise and IT operation. There are far more people and process issues to be addressed and migrated. And there are more enterprise and outsourcer business needs to be met." Overcoming these issues takes time - usually two to three years with the biggest deals, says Geoff Smith, president of IT consultancy LP Enterprises and former deputy CIO at Procter & Gamble. "Beyond that point, only the truly committed strategic partners survive," he says.

For a strategic partnership to be mutually rewarding, vendors need to be flexible and willing to adapt to their clients' changing business conditions. And CIOs must bend their expectations and behaviours to allow the vendor to perform optimally. Success in strategic partnerships has less to do with contract negotiations than with the day-to-day interactions down the line. Ross says that CIOs who sign the same kind of big outsourcing deal with the same vendor can end up having completely different outcomes. "When you talk to [CIOs] about it, what you find is that they didn't have terribly different experiences in the beginning. But in one case, the situation is deteriorating and in the other case it's getting better," she says. "The ones who are happy are the clients who say: 'Change is to be expected and we'll work this out'. And those that aren't are the clients who dig in and resist change."

But getting to that state of healthy interdependency takes time, trust and more management overhead than any other kind of outsourcing effort.

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Getting Off on the Right Foot

The relationship between Campbell Soup and IBM wasn't always a good one. The $US7.5 billion food manufacturer's 10-year deal with IBM for IT infrastructure and operational support dates back to 1995, when the existing management signed the contract in an attempt to reduce IT costs. By the time Wright arrived as CIO in 2001, though, the relationship was on the rocks. Campbell's CIO position had turned over three times since the signing of the contract, with each new IT leader leaving his own imprint on the partnership. One was as opposed to the outsourcing as the next was gung ho about it. One of the CIOs was so disillusioned with IBM that he duplicated the entire infrastructure group internally to oversee what the outsourcer was doing, Wright says, adding: "There was obviously a level of mistrust."

Wright began to remedy the situation by eliminating the duplicate functions, drawing a clear line between what IBM was responsible for and what Campbell owned. Then she began the longer-term rehabilitation of the badly broken partnership. "We just took a clean sheet of paper and looked at every single thing each of us performed and asked who should perform it, both today and in our future state," says Wright. With Gartner mediating, Campbell and IBM spent a year reorganizing the outsourcing arrangement. In the end, although Campbell took its help desk back in-house, the company ended up outsourcing even more to IBM. That year of planning was critical in setting the tone of the relationship and setting the stage for a true partnership. "After that, we knew about how to work together and what our roles were," Wright says.

Ontario Power Generation (OPG) also took its time in laying the groundwork for a successful strategic partnership. When OPG decided to outsource 80 percent of its IT functions and services to a single vendor in late 1999, it was a huge leap for the Toronto-based energy provider. "It was our first jump into the IT outsourcing world," says CIO Dietmar Reiner. "And it was the only large-scale outsourcing deal ever done in our company."

The driving factor behind the outsourcing plan was deregulation of the electricity market in Ontario, which would force OPG to reduce its market share in the province from 90 percent to 30 percent. OPG's centralized IT structure, which had provided internal economies of scale, would be impossible to sustain as the company sold itself off in chunks. An external services provider could provide that centralized IT resource without unit costs going through the roof. In addition, Reiner recognized that he would have to pare down his IT staff as the company divested itself of assets. Partnering with an outsourcer could provide those IT employees with a safe place to land.

Still, Reiner knew the nine-year, $C1.14 billion deal with Cap Gemini Ernst & Young (CGEY, now known as Capgemini) was a big step for a first-timer. So he took extra precautions to make sure the relationship started off on a solid footing. Rather than jumping into a traditional outsourcing arrangement, in which the client contracts with an independently owned vendor, OPG launched its strategic partnership with CGEY as a joint venture. OPG retained a 49 percent share of the CGEY subsidiary that would supply the IT services, and OPG executives (including its CIO, CFO and COO) made up half of the board of directors. "Jumping into what was largely the unknown, this [joint venture] gave us a vehicle to mitigate the risks," Reiner explains. The joint venture also provided some safety for CGEY.

The original plan was to sell OPG's interest in the entity to CGEY after two years and move to a traditional outsourcing arrangement. The joint venture period gave OPG and CGEY time to put in place new processes for running IT, as the entire organization learned how to operate under the new model. "We were coming from an organization with an internal IT shop that didn't have any service levels in place. Everything was done on a best-effort basis," says Reiner. "The move from that into the service-level world was a big one."

The joint venture launched in February 2001, and 550 of OPG's original army of 700 IT staff became its first employees. In April of the following year, CGEY bought the company in full. Still cautious, OPG introduced a unique element: a "gain-share phase", as a bridge from joint venture to fixed-price deal.

Common outsourcing wisdom holds that CIOs should try to squeeze all the efficiencies they can out of their internal IT shops before entering into a large outsourcing deal. OPG had not done that. The gain-share phase was a two-year contract that encouraged the elimination of inefficiencies by giving OPG and CGEY an equal share in any IT cost savings. "We knew that Cap Gemini needed to make some kind of profit margin on this business. But we didn't want to leave money on the table. So we introduced an incentive that would encourage them to cut our costs," says Reiner. "We came up with the idea jointly. It comforted us, and they shared in the financial benefit." OPG and CGEY finally moved to a more traditional strategic partnership model mid last year.

With an outsourcing deal as complicated and risky as a strategic partnership, CIOs should take time to learn how best to work with an outsourcer and to assess what each party can - and more importantly, can't - do. "Part of what goes on when these things fail is that the client's expectations of what the vendor can accomplish for them are just not realistic," says MIT's Ross. "And part of what goes on in a successful strategic partnership is a learning process. You can't just say: 'Here are my demands'. You have to figure out what works for both parties."

The Demand for Hands-On Management

The root cause of many a dysfunctional strategic partnership is the misguided notion that by outsourcing a sizeable portion of the IT pie, a CIO is outsourcing a whole hunk of IT management responsibilities as well. In fact, it's quite the opposite. As Ross explains: "Any good partnership has enormous overhead."

That came as a surprise to Reiner at OPG. "One thing we didn't recognize initially was that it takes significantly more work to manage a relationship like this," he says. Rigorous management is required to strike a balance between the competing interests of client and vendor. "The service provider is motivated by profit, and we're looking at cutting costs and extracting value. So there's a natural tension," says Reiner. At each phase of the relationship - from joint venture to gain share to strategic partnership - the two parties learned more about the middle ground between what the outsourcer needed and the business required.

Yet keeping the relationship on an even keel remains difficult. "It's taking a lot more effort than we thought," Reiner says. "You have to have the proper processes in place, the proper governance, the proper escalation when things go wrong. And, you have to be on top of all of that all of the time."

Ross says that in a strategic partnership, a smart CIO will pull representatives from the outsourcer into the IT governance structure to provide input on future technology decisions. Jefferson Regional Medical Centre (JRMC), a 376-bed hospital in Pittsburgh, signed an eight-year outsourcing contract with Siemens in 2001 to stem nearly five years of losses while also upgrading its entire IT infrastructure. The two parties agreed to a joint management structure to help align IT and enterprise objectives.

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The IT executive committee comprises JRMC CIO Jim Witenske and a Siemens site executive, along with JRMC's CEO, COO, CFO and four vice presidents. The committee meets monthly to discuss the status of all existing IT initiatives and to discuss new projects that could lead to more efficient or effective patient care. "I've been in some us-versus-them outsourcing deals and this isn't one of them," says Witenske. "We share a common interest in meeting the strategic needs of this institution." Ron Forsys, the Siemens site representative, adds: "A lot of it is about relationships. Jim and I have a good relationship and we can call on each other for any problem, whether it's related to the Siemens partnership or not."

The joint management team has pinpointed specific areas, such as billing, contract management and human resources management, where new systems and automation could most immediately help turn around the financial losses. Those savings have been pumped back into new patient care initiatives and other new systems to support those initiatives.

So far the strategic partnership is paying off. Siemens has eliminated $US3 million in annual IT operating expenses, deployed 30 new applications and stabilized the IT workforce, which, other than Witenske, is 100 percent employed by Siemens. JRMC's overall IT budget has remained flat, and the new systems helped the hospital get back into the black last year. "Our CEO absolutely credits the strategic partnership with being part of the turnaround," says Witenske. "Sometimes you just need to bring in an outside partner to help you change things and have a positive impact."

Flexibility to Avoid Failure

An odd thing happens in successful strategic partnerships: CIOs look beyond their own needs and spend a lot of time thinking about their vendor. "People who are happiest with their strategic partnerships talk a lot about what their vendor needs," says Ross. This willingness to extend a hand leads to flexibility on the part of the vendor. "[CIOs] will tell you: 'When I told [my vendor] I had to cut my budget, they understood and helped me out'," Ross says.

Back at OPG, Ontario's provincial government decided in 2003 to reregulate the electricity market. So the company's original case for setting up a strategic partnership was gone. But Reiner has a whole host of new reasons to continue the relationship with CGEY. IT performance levels and systems availability have gone up, and "we're further ahead financially than we originally anticipated in the business plan", he says. For its part, CGEY has been able to sell its services to other clients in the energy industry and spread its costs over multiple clients.

"For both of us, it's still the right decision," says Reiner. "But we have to manage it and stay on top of it." That includes controlling processes, reviewing service levels and conducting monthly joint meetings with CGEY to review the relationship. Reiner also brought in an outside outsourcing consultancy to review the relationship with CGEY. The consultancy advised OPG and CGEY to further clarify their roles, responsibilities and service levels. It also advised both parties to step up efforts to move to a fixed-price model.

Although paying for outsourced services on a time and materials basis (which OPG had been doing for four years) is how most strategic partnerships start out, fixed-price is the goal. "[Currently] we drive down the cost of the service to OPG by driving down time and materials costs," Reiner explains. "This requires us to be involved in the outsourcer's business at a level of detail that we should not be involved in. And we effectively have two management teams. A fixed-price model will let [CGEY] focus on managing their internal costs for providing services and let OPG focus on managing demand and levels of service."

At Campbell Soup, Wright tries to take any guesswork out of her strategic partnership. She keeps IBM in the management loop so the outsourcer can always anticipate what is ahead. "Some CIOs are so secret with their vendors. But if the vendor doesn't understand what you need - if they don't understand your strategic plans, your operating plans, what IT's role is in the business - it's hard for them to be a good partner," says Wright. "And it's not something we share just as a good-faith effort. If a vendor understands what we're trying to accomplish, we expect them to be able to plan in a way that saves us money."

Yet even with all the openness and joint effort, strategic partnerships don't always work out right. "There are times when things go wrong, just as if we were running it [in-house]," Wright says. "You have infrastructure problems. A project manager doesn't work out. Someone screws up." Just recently, Wright was unhappy with the performance of IBM's lead partner on a big systems project. And one of IBM's subcontractors was causing Campbell a major headache in the form of four severe network outages in one day. But Wright measures the success of her strategic partnership not in the problems that crop up but in how IBM works to solve them. In both cases, she says, the vendor devoted a lot of time to solving the problems.

The best way to judge the health of a strategic partnership is to look at how both sides react to the unexpected, says Smith of LP Enterprises, who helped negotiate several such deals at P&G. "If there's a major drop in the service levels, does the client instantly invoke a multimillion-dollar penalty clause, or is there some understanding and flexibility working toward a mutual resolution of the issues? If the client makes an acquisition and there are new IT needs beyond the scope of the original contract, does the client say to the vendor: 'This should all be included - just eat the costs'? Do they create an RFP and say to the vendor: 'Hey, you're just one of five bidders on this contract and you're just another vendor to me'? Or do they say: 'This is new business beyond the scope of our agreement and because you're my preferred supplier, you get first crack at it'?"

"Like any relationship, you have to put in a lot of time and effort," says Wright. "And we're making changes and working on it all the time. But it's been the right thing for us."