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June 26th, 2010 by Rahul Jain
Dr. Oliver Williamson may not be a household name in IT outsourcing circles, but a consortium of academics is hoping to change that. Williamson, professor emeritus of business, economics and law at the University of California-Berkeley, won the Nobel Prize in Economics in 2009 for his examination of economic governance. Some outsourcing researchers say his lifelong study of transactional cost economics—the practice of accounting for the total costs of a contract, both obvious and hidden—contains valuable lessons for anyone engaging in outsourcing today.
Kate Vitasek, a faculty member in the University of Tennessee’s Center for Executive Education and author of Vested Outsourcing: Five Rules That Will Transform Outsourcing, along with three other academics culled Williamson’s work for lessons on improving performance, reducing costs and increasing satisfaction when outsourcing. (The full white paper is available for download. Registration is required.) Here are seven of their suggestions.
1. Build cooperation into the contract.
In an article on transaction cost economics and outsourcing management, Williamson wrote that “efficiency gains from trade go back to when our ancestors traded nuts for berries on the edge of the forest, [in] which exchanges were both transparent and simple.”
Modern outsourcing relationships, by contrast, are manifestly more complex. But Williamson maintains that additional gains can be realized if the outsourcing customer and supplier create processes to preserve cooperation throughout the life of the deal. For example, outsourcing partners should ask, “What’s in it for we?” instead of “What’s in it for me?” says Vitasek. “Don’t just say ‘win-win’. Contract for a ‘win-win’.”
2. Factor in hidden transaction costs.
No outsourced project ever costs what it purports to in the contract. In fact, the dotted line and the bottom line can be pretty far apart. Figuring out what an outsourcing deal will actually cost in the long run is tricky, but crucial.
“Every contract structure and relationship, especially in a vested, collaborative partnership, should account for risk, asset specificity, frequency and work to be done,” Vitasek says, “or else it’s not much of a contract.”
One-sided contracts that push all the risk on either the service provider or the customer will cost more in the long run.
3. Use the contract as a framework, not a weapon.
Outsourcing customers—particularly those who’ve been burned before—may be tempted to create an overly detailed contract to cover every possible contingency. That’s a mistake, according to Vitasek’s interpretation of Williamson, not to mention impossible.
“It limits innovation and encourages finger-pointing when there is inevitable scope creep and changes,” Vitasek says. “Instead of trying to guess about the future, it is better to indicate an outline of the work to be done and provide recourse for ultimate appeal. For work yet to be determined, focus on the process and tools to be used, not on the work to be done.”
4. Make end-of-life arrangements early.
Outsourcing partnerships can’t last forever, so it’s constructive to plan for the end early on. With “feasible foresight,” Williamson wrote in the Journal of Supply Chain Management in April 2008, an outsourcing customer can mitigate the effects of a defection from its services provider.
“It is important to recognize that business relationships may need to change due to changes in the market, and for this reason, contracts need a well thought out exit management plan,” says Vitasek. “Practitioners should clearly identify the costs associated with terminating a contract [and] create safeguards in the contract that are fair and equitable in terms of keeping either party whole in the event that a contract needs to be terminated prematurely.”
5. Create a shared vision statement.
If you can identify strategic points of alignment with your outsourcer, you will minimize additional transaction costs over the life of an IT services deal. Vitasek advises creating a shared vision statement to guide the relationship. She also recommends developing pricing models that reward service providers for achieving joint goals.
6. Play nice (but not too nice).
Sure, you can strong arm your supplier at the negotiating table—or be strong-armed—but either style of contracting will come back to bite you. Organizations that use what Williamson calls “one-sided muscular contracting” to gain advantage over an outsourcer will see only short-term gains, says Vitasek.
“[They] will ultimately face higher market costs and transaction costs from switching or transitioning suppliers, or from suppliers being forced to use conventional negotiations to put in myopic and costly contractual provisions and behaviors that simply drive up hidden costs.” Williamson also warned against “idealistic benign contracting,” which assumes that most people will do what they say—and some will do more—most of the time.
The Nobel laureate recommends a middle ground of “credible contracting,” which he describes as more “hardhearted wise” than its extreme alternatives. Credible contracting is “also flexible enough to acknowledge that complex contracts, by their very nature, are incomplete and thus require cooperative adaptation,” Vitasek says.
7. Always leave money on the table.
Most outsourcing customers and suppliers assume that leaving money on the table is, at best, wasteful, and at worst, foolish. Not so, says Williamson. Hard bargaining negotiations to get to the lowest possible price actually cost both the customer and the provider in the long run.
“Successive ploys and counterploys of this kind could plainly jeopardize the joint gains from a simpler and more assuredly constructive contractual relationship,” wrote Williamson. “Always leaving money on the table can thus be interpreted as a signal of constructive intent to work cooperatively,” thereby mitigating “concerns over relentlessly calculative strategic behavior.”
Of course, he also notes the effectiveness of this tactic varies based on the level of trust among those involved.