Problem Solving

Keep Outsourcing Relationships Short Term

Donald Mitchell asked:

Consider outsourcing and you’ll find eager companies and suppliers lined up to offer you long-term contracts. Why? Assuming that the outsourcing provider performs as promised, you are locked into using their service . . . even if a better alternative arises. The more profitable the arrangement is for the provider, the more that organization will want you to sign a long-term deal.

All kinds of reasons will be offered to justify a long-term arrangement. A typical explanation goes as follows: The supplier has to make a capital investment to start serving you and needs you to stay with the supplier long enough to allow the company to recoup the costs.

While that’s highly desirable for the supplier, you have to also consider if it’s equally desirable for your organization. Can the capital investment be used by a large number of other customers?

If yes, why should a long-term contract be required? If not, what would be a fair payment be during a shorter contract to compensate the supplier for having made the initial capital investment?

Others will tell you that they lose money during the first year and need several years to recover that cost. What they may not be telling you is that a lot of those costs are selling expenses that the outsourcing provider should be absorbing.

As a consultant, I’ve often seen other consulting firms become established inside companies. They seem to live permanently inside the client.

Under such circumstances it’s not unusual for the consulting firm to have a five-year contract in exchange for a modest discount in hourly rates. Long before the contract term is over, consultants priced at over $300 an hour may be doing work that could have been supplied elsewhere at $10 an hour. No matter how discounted the consulting price is, the client didn’t get a good deal.

This kind of arrangement can be pretty hard on organizational morale, especially during hard times. Staff members often complain bitterly when they see wasteful spending on consultants. Every decision in the company may find its way through the consultants, both slowing down progress and making progress more expensive as the consultants find ways to grab pieces of the workload.

I’ve heard people who haven’t had a raise in two years say that they would be glad to do the same work on their own time for $15 an hour just to get a little extra income. It’s pretty galling to see relatively inexperienced MBAs strolling around charging consulting rates when they typically know less about the issues than the people who work in the organization.

Sometimes, overly expensive long-term relationships sneak in the back door as a way to accomplish some other purpose. Before such relationships were restricted by legislation in the United States, accounting audit firms could sell clients other types of professional services.

If the auditors found a process problem while reviewing internal controls, the auditors would prepare a proposal to solve the problem on an outsourcing basis. Because other outsourcing firms didn’t know about the problem’s background, it often seemed logical to hire the auditing firm to do this work at full price.

Although auditing contracts were usually for a single year, public companies were generally reluctant to change auditors very often. Such changes could create a public presumption that the old auditor turned up some sort of accounting problem that the public company wanted to keep quiet.

As a result, most public companies worked with the same auditors for a decade or longer. The longer those relationships lasted, the bigger the outsourcing bills became.

There was another subtle influence at work in some cases. CFOs who wanted to use questionable accounting methods would be sure to spend plenty on the auditing firm’s latest outsourcing ideas.

The accounting firms would often find accounting methods that deferred, capitalized, or otherwise kept their fees from hurting current profit levels. With so much money at stake for the auditing firms, some accounting partners became more focused on the auditing firm’s profits than on the integrity of the organization’s books they were auditing.

A parallel pattern of excessive influence showed up in many public companies’ relationships with U.S. investment bankers. Journalists have reported that some senior executives in public companies were allotted large numbers of shares in hot initial public offerings (IPOs) by investment banking firms seeking more business from the executives’ firms.

These executives could in some cases flip the IPO shares for a 200 to 300 percent gain in a single day, making as much as several hundred thousand dollars. Some would call such accommodations nothing less than bribery.

These same executives also received a lot of their compensation in the form of stock option grants. Investment banks were in a position to encourage their security analysts to write more favorable reports about public companies that spent more on fees with the investment bank.

In fact, the security analysts were often in the dual role of salespeople for outsourced investment banking services and security analysis for the public investors. A senior executive who wanted to earn more often found it to be beneficial to reward investment banks with higher fees. Like the accounting firms, investment banks found ways to package these fees so that they did not affect current earnings (and lower executive bonuses).

This pattern of using outsourcing to gain other purposes shows up in other parts of organizations. Local plant managers have often used outsourcing contracts to reward relatives of local officials who were in a position to aid or harm company efforts. In other cases, this prerogative was abused by being used instead to gain personal favors for the manager’s family.

What all of these back-door relationships have in common is that they don’t receive much scrutiny, aren’t well understood by any but a handful of people in the organization, and are seldom compared to alternatives. It’s no wonder that long-term outsourcing relationships often become tainted by bad apples.


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