When UK optician chain Vision Express signed a four-year outsourcing deal with service provider ITNet recently, the company’s IT manager David Hart was determined that past mistakes would not be repeated.

A previous outsourcing relationship, he says, ran into problems when the provider (whom he declines to name) failed to live up to Vision Express’s expectations. In retrospect, Hart believes that, had the terms of the relationship been more clearly defined from the start, many of the problems Vision Express encountered might have been avoided. “In that relationship, clarity of scope was sorely lacking. In fact, it was never adequately defined,” he says.

Vision Express’s experience with its former outsourcing provider is regrettably common. Indeed, outsourcing contracts are notoriously frail. Duncan Aitchinson, managing director at outsourcing advisory company TPI, predicts that half of all outsourcing deals in Europe will fail during the next 12 months because of poor management.

Aitchinson’s dire predictions are backed up by recent research from analysts at IT market research company Gartner, which recently stated that the chances of outsourcing deals succeeding is “about 50/50”. Analysts at another research company, Giga Group, are slightly less damning, but their predictions are hardly good news for outsourcing customers: they point to a recent survey conducted by business information specialists Dun &Bradstreet that suggests that 20% to 25% of outsourcing engagements fail within two years, and 50% fail within five years.

According to Aitchinson, many organisations are now rushing into outsourcing deals in a bid to save money during the current economic downturn. But in their haste to cut costs and get projects up and running as quickly and as cheaply as possible, they frequently neglect to look at the long-term impact outsourcing will have on their businesses. “Approach an outsourcing contract with the same rigour as you would a merger or a divestment – in other words, as a major business change. That is the way to create the right mental state,” he says.

Recent high-profile outsourcing failures have done much to bring these problems under the spotlight. In August 2002, for example, the Bank of Scotland, which last year merged with Halifax Bank to form HBOS, decided to terminate a 10-year, £700 million outsourcing contract with IBM after less than two years and bring its IT functions back in-house. The move is likely to cost the bank a substantial sum in one-off transition costs – possibly running into tens of millions of pounds.

Likewise Capita, another outsourcing provider, came under fire in late August 2002 when its customer, the Criminal Records Bureau, was unable to vet teachers in time for the start of the school year. Education secretary Estelle Morris told Channel 4 News she was “a very dissatisfied customer”, adding that the outsourced system “did not have a history of working very well”.

And yet, despite such failures, outsourcing deals continue to be struck. According to Morgan Chambers, an advisor to large companies on outsourcing issues, around 56% of FTSE 100 companies have embraced outsourcing. And a recent

report from IT market research company Meta Group predicts that “nearly all” IT departments will outsource at least one mission-critical technology operation by 2005.

The challenge is neatly summed up by analysts at IT market research company Giga Group: “Outsourcing is increasingly viewed as a strategic tool companies can employ to improve earnings, improve service, mitigate risk and concentrate on core competencies. Our research has found, however, that very few companies establish formal management methodologies and processes to oversee these relationships.”

So how should technology decision-makers go about building outsourcing relationships that will last, and that will add to – not subtract from – the bottom line?

Full disclosure

“Failure to disclose all the material facts to the outsourcer – usually because of a lack or preparation or quality data – by the user before warranties are signed in the contract is a fatal mistake,” says Phil Morris, director of Morgan Chambers. The best way to mitigate risk, he says, is relatively straightforward: customers must know what they are handing over to the outsourcer, and outsourcers must have a clear understanding of what exactly they are taking on. “Lack of due diligence,” says Morris, “causes potential financial exposure and gets the relationship with the outsourcer off to a bad start.”

But achieving the necessary level of due diligence is far harder in practice. In the case of Vision Express, this meant taking a ‘step back’ after the failure of the company’s previous outsourcing relationship and reassessing what IT functions the company should hand to a third party. “We decided that far too much had been outsourced in the past,” says Hart, citing applications management as one such function. “We decided in particular that we should never hand over strategic planning or internal analysis of our IT systems to an outside company. We trimmed down our outsourcing strategy to fit the core competence of our provider, ITNet: that is, technology hosting,” he says.

Morris of Morgan Chambers endorses this strategy: “Don’t outsource anything you don’t understand. If you can’t see how a challenge can be overcome, then don’t try handing the problem to someone else and expect everything to be fine.”

He recommends that if an organisation has an in-house system it is considering turning over to an outsourcer, it should spend at least six months benchmarking its own management of the system. This, he says, will not only acquaint it with the flaws and challenges inherent in running that system, but also of the potential benefits of handing it to a third party. Aitchinson of TPI adds that his company carries out assessment work for organisations in the period prior to supplier selection, and says that “in about 50% of cases”, TPI finds that the customer is not ready to hand that system over to an outsourcer.

Legal experts point out that a sturdy contract, containing stringent service level agreements, is also a critical factor in whether an outsourcing contract succeeds or fails (see box, Key components of outsourcing contracts).”Bear in

mind you can only realistically hope to receive the levels of service that an outsourcer has contractually agreed to provide,” advises Rory Graham, a lawyer with law firm Baker &McKenzie. Morris at Morgan Chambers adds: “Procurers should set their goals high – certainly higher than those set for the [in-house] IT department and contract [the outsourcer] to go the extra mile that in-house service could not deliver.”

However, he adds, there is an inherent danger in setting expectations overly high – and demanding that the outsourcer lives up to those expectations. “Clients must accept that the outsourcer must be able to fulfil the contract at a profit: ‘suicide’ contracts are not commercially sustainable and the days of users being ‘easy meat’ for outsourcers are long gone,” he warns. In fact, he adds, research carried out by Morgan Chambers indicates that outsourcers’ profit margins typically amount to a slim post-tax bracket of around 4% to 6%.

“If a customer squeezes too hard on contract terms, that contract is clearly less desirable for us,” admits Martyn Proctor, director of SAP services at ITNet. “The danger of inflicting hefty penalties on an outsourcing provider is that fear of those penalties becomes the defining factor in the relationship,” he says.

Even the most carefully thought-out contract needs careful, ongoing monitoring, says Morris of Morgan Chambers. “Unless the customer sets up a high-calibre, dedicated, adequately resourced contract management team, the relationship with the outsourcer will inevitably deteriorate,” he says. Hart of Vision Express, for example, meets up with ITNet on a monthly basis to discuss short-term performance metrics.

The company also built annual reviews, alongside less frequent ‘break points’ into its contract to support more long-term, strategic assessment. “If the relationship is to remain flexible and continue to support our goals as an organisations, it is vital we keep ITNet informed of the directions we’re going in,” says Hart. Graham of Baker &McKenzie also advises clients to hold annual or bi-annual reviews. “You need to step out of day-to-day SLA measurement to look at the relationship as a whole,” he says.

“The goal of any successful outsourcing deal is a win-win outcome,” agrees Phil Morris of Morgan Chambers. “This is an imperative for achievement of sustained long-term success with outsourcing. Therefore, a balance needs to be found between control and flexibility and risk and reward.” But it is a balance that too many organisations – and their outsourcing providers – find difficult to strike.

But are incentives or penalties the best way to ensure good service from an outsourcing provider? Hart of Vision Express thinks not: “If things end up with you having to manage your relationship via penalties each month, then you have failed in outlining your scope adequately.”

This time, claims Hart, Vision Express has got its outsourcing relationship right. “There is a clear schedule of obligations which we have specified. We believe it to be sensible. We do not look to penalise or reward – we just expect the partner to deliver the documented scope.” And so far, he says, ITNet has consistently lived up to his expectations.