Securing pricing is a struggle for every manufacturer who enters into an outsourcing partnership. But is focusing on reducing part and service prices the best way to lower your total outsourcing costs?
I recently spoke with Kate Vitasek, a faculty member at the Center for Executive Education at the University of Tennessee, and co-author of Vested Outsourcing: 5 Rules That Will Transform Outsourcing, about how a Vested Outsourcing approach can help manufacturers develop better outsourcing relationships, and cut outsourcing costs.
Alex: Tell us about your work at the University of Tennessee and what led you to Vested Outsourcing.
A few years ago, the University of Tennessee asked me to lead a project to identify best practices in outsourcing. My team looked at a lot of deals, and saw what worked and didn’t work. We looked at the research around outsourcing relationships, research done by Nobel-prize-winning economists that showed why certain elements of outsourcing deals work, like behavioral economics and transaction cost analysis. We wanted to help people understand not just the how but the why.
With my two colleagues, Mike Ledyard and Karl Mandrodt, I wrote a book that came out in early 2010 called Vested Outsourcing: 5 Rules That Will Transform Outsourcing. This past summer, we published a second book, The Vested Outsourcing Manual: A Guide for Creating Successful Business and Outsourcing Agreements. We also introduced an online course and a suite of education and consulting services to help people implement Vested Outsourcing deals. It’s been truly amazing and exciting to see how much interest there is. A lot of people are struggling and unhappy with their outsourcing deals, and Vested Outsourcing shows them a better way.
Alex: What is the Vested Outsourcing model?
Kate: Vested Outsourcing is a hybrid model that combines outcome-based thinking with relational economics and shared value principles. It’s about creating business agreements where both the buyer and the service provider collaborate to solve business problems—creating a vested interest in each other’s success. In a Vested Outsourcing partnership, partners focus on transformational initiatives that generate value, rather than what it costs for the service provider to perform an activity.
We’ve identified 10 elements of a successful outsourcing relationship, using the term “vested” because these deals provide both parties with a vested interest in helping each other be successful. In a Vested Outsourcing partnership, working together is absolutely critical. If you allow your outsourcing relationship to become adversarial or positional, you squelch the potential for transformative solutions that can reduce costs and improve service in ways you could not imagine.
What makes Vested Outsourcing different from other outsourcing models?
Most new outsourcing efforts are driven by a desire to reduce costs, and companies just venturing into outsourcing start from the mistaken premise that reducing price automatically means reducing costs.
Sure, if your sole driver is a lower price you can achieve short term cost reduction, but if you’re not collaborating with your service provider, you’re going to miss out on the opportunities for innovation and total cost reduction through process transformation.
And think about what happens when you shop your deal to see if you can get a better price. There are the transaction costs. You spend resources on the RFP process. Your service provider does the same. Then you have transition costs, which can go way beyond the dollar cost when you consider the disruptive effects on your supply chain or your customers.
So, in many deals, focusing on price just isn’t the smartest way to go about it. In a Vested Outsourcing model, you work together with your service provider to transform your processes and find the value, and this ultimately leads to greater cost reduction.
What are the top risks in outsourcing, and how can Vested Outsourcing help?
I’d say the number one risk is transaction-based pricing. By that, I mean defining a scope of work based on activities—picking, packing, shipping, answering calls, storing servers, etc. We call this the activity trap. If you pay your service provider for every activity, there is no incentive for the service provider to become more efficient.
Now you say you want cost reduction, you say you want transformation in your supply chain, but what did you just buy? You bought activities. You didn’t buy creativity. You didn’t buy innovation. When you just pay for activities, you provide your service provider with absolutely no incentive to innovate. An improved process to reduce activities means lower revenue for the service provider. Why would any service provider voluntarily give up revenue?
A Vested Outsourcing deal structures the pricing model in such a way that the buyer and the service provider both have financial incentives to innovate. One example of this is margin matching. If you (the service provider) figure out a way to streamline a process, than I (the buyer) will pay you your margin on the activities you’ve eliminated, plus a reward for innovating. Additionally, I will cover the costs of the technology required to implement the innovation.
This is an example of the win-win situations in Vested Outsourcing—the buyer ultimately comes out ahead, and the service provider is incentivized to improve the process, which leads to better end-user satisfaction. So everybody wins.
What are some outsourcing problems that Vested Outsourcing addresses?
The most amusing problem Vested Outsourcing addresses is what I call the “Watermelon Scorecard.” This situation occurs when you build your contract around activities, set your KPIs and SLAs, and watch what happens.
Usually, even if your service provider’s scorecard is green, you’re unhappy—red on the inside—because you’re not getting what you really want. (All too often buyers think what they want is a green scorecard—and once they get it they realize they really wanted business outcomes.) To fix that, you have to step back and clearly communicate what you really want, then build an agreement that provides the proper financial incentives to your service provider to give you what you want.
Another issue Vested Outsourcing addresses is the distrust that sometimes occurs between the buyer and the service provider. Distrust is a clear symptom that the deal isn’t right, and the big challenge here is breaking down the buyer and seller’s win-lose mental habits and adopting a collaborative approach. This way they can work together to reduce cost structures and drive efficiencies.
When one of the parties is larger than the other, we sometimes see what we call the “800 Pound Gorilla Syndrome.” This happens when buyers try to irrationally squeeze the service provider on pricing. Buyers don’t always realize that if they keep squeezing, it actually poses a threat to the service provider’s viability.
Remember, if you strip the service provider’s margin, the service provider will get it back one way or another. They have to—they have EBITDA requirements just like you do!
How does Vested Outsourcing help organizations manage change and reduce costs?
There are two key principles of Vested Outsourcing that can really improve how you manage change and cut costs.
First, work with your partner. I can’t emphasize this enough. If you are unable or unwilling to collaborate, you’re shooting yourself in the foot unless you are 100% certain that you have all the answers.
Second, be clear about what you want to accomplish. We call this “defining your desired outcomes.” From the desired outcomes, you sketch out what needs to happen to achieve those outcomes. We have developed a tool we teach in our classes called the Requirements Roadmap. The Requirements Roadmap is a great way to help companies rise above thinking about activities and service levels.
How might manufacturers apply key principles of the Vested Outsourcing model to improve their outsourcing relationships?
First of all, I highly recommend manufacturers educate themselves about the economics of outsourcing and the literature on what makes outsourcing deals succeed or fail. They can start with the white papers we have on our site which are free as downloads.
Most people think outsourcing is all about price, so they think getting a good deal means getting the best price. But there are serious flaws in that approach when you need your service providers to be smart and help you respond to the constant changes in the marketplace. If you need innovation in your supply chain, it is just plain stupid to outsource purely on price. You have to shift your focus to value.
How do you define the value you need in order to be successful? Which outsourcing partner is best qualified to help you succeed? Notice I said best qualified, not cheapest.
Does Vested Outsourcing work across all industries?
Well that’s a very interesting question because in principle, yes, you can apply the concepts of Vested Outsourcing in any industry, but not every deal needs to be a Vested Outsourcing deal. Let me explain.
In our research we have seen Vested Outsourcing deals in almost every type of service and industry. However, just because you can do a Vested Outsourcing deal does not mean it is right for your business.
If you’re buying pure commodities, you really don’t need to use a Vested approach as long as what you are buying is already extremely efficient and you feel you are getting value from letting the market set the price/value equation. Vested Outsourcing is best suited when you want your service provider to be smart and creative and help you put a solution in place that can add incremental value or doesn’t yet exist.
The simple litmus test I have for a company is this—do you have any desired outcomes? A desire is something you want – and an outcome is a business result. So if your company has desired outcomes you are not currently getting from your service providers, Vested Outsourcing may be a good fit.
Any other thoughts?
Well I just want to thank you for asking the questions. And to the COO or CFO or Chief Procurement Officers, I would say asking questions is a good place to start. Question your assumptions about what makes outsourcing relationships work. Look at the research. Consider alternatives to conventional transaction and price-focused approaches. The “I-win-you-lose” approach is really outdated if you are trying to create value—and that is the name of the game in the 21st century.
It is imperative that companies create outsourcing deals that provides financial incentives to both the buyer and the service provider to collaborate and innovate to create breakthrough solutions. This will mean changing practices, changing mental habits, and re-learning, but our research shows it pays off.
For more information:
Kate Vitasek’s approaches and insights have been widely published with more than 200 articles in respected academic and trade journals, including the Journal of Business Logistics, Supply Chain Management Review, Inside Supply Management, Forbes, Chief Executive Magazine and Aviation Week. She is also a columnist for Outsourcing Magazine and Procurement Leaders Magazine.