In other cases, the ailment lies hidden deeply within the relationship – and neither the company outsourcing nor the service provider knows it’s there. At first, no physical signs of the ailment may be evident, but left unchecked it may fester into something bigger. In the worst cases, the problem can become so endemic that it eventually causes the death of the relationship, which leads the company to bring the outsourced services back in house or induces it to switch suppliers.

Our research and experience have exposed the 10 most common problems in outsourcing agreements. We regard these as ailments that can plague and potentially destroy an outsourcing relationship.

Let’s start with the first and the easiest ailment to identify. The one that materializes when a company outsources based purely on costs. We’ve all heard the warning against being “Penny Wise and Pound Foolish.” Unfortunately, many procurement professionals are still in the dark ages. Too many companies profess to have an outsource “partnership” while behind the scenes they focus solely on beating up their service providers on price.

When outsourcing, you need to think beyond the short-term bottom line. The danger in focusing on the cheapest offer is like anything else – you make trade offs in quality, service or both. Unfortunately, many executives view outsourcing as a “quick fix” solution to resolving balance sheet problems. Often companies suffering from a case of “Penny Wise and Pound Foolish” tactics fall into a loop of frequent bidding of their work to the lowest price provider and making the transition to reliance on that supplier. This tendency can lead to a vicious cycle of bid and transition, bid and transition, bid and transition. Companies that become caught in this cycle typically end up with unintended disadvantageous consequences such as these.

Outsource providers that work with the company eventually will refuse to work with the company again. They become tired of getting beat up on price, only to have their efforts rewarded by losing the work the next time around. Ultimately, they choose to pursue revenue from more productive outsourcing relationships. In one extreme example we witnessed a company re-bid their transportation services every three months. In this case the company had recklessly churned through nearly all of the top 20 suppliers during a five-year period, and consequently was forced to work with suppliers of lesser quality.

Outsource providers bid such low prices in order to work with a company that they go out of business; the outsourcing company consequently struggles to find a new outsource provider. One company, as an example, was described by its suppliers as an “800-pound gorilla.” This company dabbled with outsourcing in manufacturing and had some successes. As a result, company executives decided to outsource all manufacturing to allow the business to focus on core competencies – s strategy that usually is a smart move. The book of business was worth roughly $100 million in revenue for the winner. In this case, three contract manufacturers had the experience and scale to manage the outsourcing company’s work volume. The “800-pound gorilla” strained its relationships with its vendors, however, by putting them through several rounds of extreme negotiations to save the last possible dime on the multimillion dollar outsourcing deal. Following the grueling negotiations, the company awarded the work to a $1 billion outsource provider, which achieved an estimated 10 percent increase in revenue as a result of the transaction. The problem? The outsource provider “bought” the business, and eventually could not sustain the losses of profit. The overwhelmed vendor gave the “800-pound gorilla” a 30-day notice that it would no longer manufacture the outsourcing company’s products and went into bankruptcy – eventually tanking what was once a successful and profitable $1 billion firm.

Organizations that engage in this spendthrift ailment give outsourcing a bad name – and should not be outsourcing in the first place. Their myopic focus might pay off in the short term, but this approach has proved time and time again that being Penny Wise and Pound Foolish does not pencil out for vendors – or for outsourcing companies.

The result is an impressive document containing all the possible details about how the work is to be done. At last, the perfect system! However, this “perfect system” is often the first reason that the company will fail in its outsourcing effort. That’s because it’s the company’s perfect system, rather than one designed by the provider of the services. We call this disease the “outsourcing paradox.”

Thought leaders in performance-based concepts warn that an ill-written task-frequency specification sometimes can create harmful and insurmountable obstacles to a successful contract. A too-tightly written statement of work makes outsource providers responsible for the work without giving them authority to exercise their own initiative in carrying out the work, as Vince Elliot observed in his 1991 article “Task-Frequency Specs: Time for a Change?” published in Cleaning Management Magazine.

We found a classic real-world example of the “Outsourcing Paradox” at work in a third-party logistics (3PL) provider that runs a warehouse of spare parts. During our site visit we saw about eight people servicing a facility that on average had fewer than 75 orders for spare parts per day. We asked why the company needed that many people at the site. We were told, “That is what the company that is outsourcing requires per our statement of work – so I have staffing at that level to meet the contract requirements.”

We are continually amazed to find that companies have chosen to outsource to the “experts” – yet then define the requirements and work scope so tightly the outsource provider winds up executing the same old inefficient processes. This disease can be exacerbated when coupled with another condition we call the Junkyard Dog Factor.

The Activity Trap can manifest itself in a variety of transaction-based outsource arrangements. When the contract structure is cost reimbursement, the outsource provider has no incentive to reduce costs because profit is typically a percentage of direct costs. Even if the outsource provider’s profit is a fixed amount, the typical outsource provider will be penalized for investing in process efficiencies to drive costs down. In a nutshell, the more inefficient the entire support process, the more money the service provider can make.

Perverse incentives play a major factor in the Activity Trap as well. Nineteenth-century paleontologists traveling to China used to pay peasants for each fragment of dinosaur bone (dinosaur fossils) that they produced. Bill Bryson, author of A Short History of Nearly Everything (Broadway Books: New York, NY, 2003) said the paleontologists later discovered that peasants dug up the bones and then smashed them into multiple pieces to maximize their payments. Or think of the farmed Hanoi rats: how many rats can you find in your outsourced processes?

The table below on the next page outlines characteristics of companies suffering from the Activity Trap in their efforts to outsource 3rd party logistics services.

Company outsourcing for services	Service providers’ typical reaction under a transaction-based model
I forecast over.	We charge you to store and count your product monthly; the more you have the more we make.
I forecast under.	We charge rush fees to expedite your products to market
I manage my suppliers poorly.	Your suppliers caused us to rework your product into new packaging. We have to charge you more money to rework.
Inventory working capital is killing me.	We don’t own your inventory – we just provide services to you. Actually, we like when you have too much because we charge to hold it.
I specified the wrong shipping requirements.	We ship as we are told. You didn’t tell us about the special label.

Source: Supply Chain Visions

Inherent in the Activity Trap is a disincentive to try to drive down transactions – another symptom seen in the Zero-Sum game. But does this really happen? Unfortunately, it does.

On one recent site visit, we asked the general manager of a third-party logistics (3PL) provider what the large area full of “orange tagged” pallets was for. She replied, “That’s some of our customer’s old inventory I need to move to an outside storage facility.” When we dug further we found out it was product that was well over five years old – and at the rate it was moving would last 123 years (that is not a typo). When we pressed further, asking why the company didn’t work with the customer to scrap the material, the answer was “Why? I charge $18 a pallet per month to store it. I’d lose revenue if I did that!”

Another victim of the Activity Trap, a large technology company, was transferring sales support activities from one outsourced provider to another. Company officials found that the data required to run certain reports was no longer current, and the new data was being stored in a new format in a different location. Because the company had not informed the current provider, the reports the provider had produced for the past five months were incorrect. In a damage-control drill, the team learned good news and as well as bad news – the sales manager who had requested this reporting had been transferred, and the new sales manager did not use this (now inaccurate) report. But preparation of the report was still a required activity, and the technology company was being charged each month to generate the report.

A third example of the Activity Trap comes from outsourced manufacturing. A contract manufacturer performed final kitting and assembly “pack-out” as a value-added service for its customer. The customer had given the contract manufacturer the bill of materials with detailed instructions to use a specified finished-goods “pretty box” for the product. Each “kit” consisted of multiple parts organized in a box. The contractor needed to assemble the box and then insert the parts in an organized manner – a process that involved 12 “touches.” The contractor charged a flat fee per “touch” to assemble the box carton, plus a fee of one “touch” for each item placed in the kit. Officials at the contract manufacturer knew that the particular box design was not efficient, but simply did what they were told rather than proactively offering solutions for an improved box design and assembly process that would have eliminated touches.

If you are outsourcing, is the agreement based on pushing the cash register button every time a specified activity is performed? If so, you’ve become caught in the activity trap.

Even if the majority of the jobs are outsourced, many companies choose to have their “best” employees stay on board to manage the new outsource provider. These same “best” employees are often the ones who were asked to help write the Statement of Work (SOW). Is it any wonder why the SOWs become rigid documents of the often less-than-optimal ways the company was performing the tasks that are now being outsourced?

Over time the “Junkyard Dog” ailment affects the outsource provider as well. Under a transaction-based model, the service provider is rewarded for work associated with the volume of the transactions. Unless otherwise compensated, the last thing an outsource provider wants to do is develop process efficiencies that eliminate their own work. Consequently, a company that otherwise might have set out on an outsourcing path to find an efficient and low-cost total solution instead achieves the lowest cost for an activity without really achieving their desired outcomes.

This phenomenon discourages innovation, first at the company outsourcing level and then within the outsource provider’s operations. The Junkyard Dog Factor often results in inefficient and overbuilt infrastructure, because personnel at each touch point in the process have tried to optimize their individual part to either keep jobs or earn revenue associated with tasks. The result is misaligned desired outcomes. The company does, indeed, get what it contracted for – but it is not really what it wanted.

While remaining conscientious about meeting the company’s expectations and maintaining associated service levels outlined in the contract, the service provider does not have an inherent incentive to raise service levels (or decrease the price) under typical arrangements, even if the industry service levels are improving. Over time, the downside of the Honeymoon Effect can lead directly to the “seven-year itch”: the supplier’s productivity levels may begin to decline if investment in its employees and technology begin to lag. Then the outsourcing company, feeling dissatisfied with their supplier’s service levels and productivity, will want to switch to a new supplier. However, as Michael Redding pointed out in his article “Managing the Risks of Facilities Management Outsourcing” (published June 7, 2006, in Real Estate Weekly), suppliers can make a switch to a new supplier prohibitively costly and disruptive.

That incremental approach makes use of the tactic of sandbagging, which is the act of intentionally concealing or misrepresenting one’s true position, potential or intent especially in order to use it to advantage.
Let’s look at a typical outsourcing example of Sandbagging. Typically during contract negotiation, someone on the company side, frequently at the senior management level, will ask, “Just how much can I save?” Rather than establish the highest level of savings achievable as early as possible (which would be most beneficial to the company outsourcing), the outsource provider will Sandbag and produce savings in smaller increments over time.

The same is true with service improvements. Why deliver dramatic improvement all up front when your hardnosed customer is just going to hammer you for more next quarter or next year? Companies know that the savings are made of up “low-hanging fruit” and long-term savings. Consequently, vendors often hold back or “Sandbag” some of their short-term improvements in an effort to manufacture savings opportunities down the line, in case they don’t perform in future quarters or years.

We all have played games in business school and simulations that prove this concept (e.g., the “supply chain beer game” or the “astronaut on the moon game”). The first step in overcoming this ailment is to recognize that participants in an outsourcing relationship should actively seek win-win solutions. Unfortunately, many outsource providers that try to cure this condition often have customers that are suffering from the Activity Trap or the Outsourcing Paradox. They want to be proactive – but they are forced into business relationships in which the contract’s pricing model offers incentives to perform non-value added activities, or in which their customers do not allow them to bring proactive solutions to the table.

According to the Aberdeen Group, assuring that negotiated savings are actually realized on the bottom line is one of the biggest challenges in organizations today. The term “savings leakage” is used to refer to the difference between the savings that were identified, and the actual savings that were achieved, as illustrated in the graphic below.

Proper measurement and follow-up of the key cost drivers are critical to preventing this “leakage.” In addition, identified leaders in this area have linked incentives to total cost savings achieved versus initial savings negotiated. In its September 2004 report titled “Best Practices in E-sourcing – Optimizing and Sustaining Supply Savings,” the Aberdeen Group reported that other companies have “secured support from company leadership to align sourcing and spending compliance with corporate goals and incentives.”

The good news is that during the past five years we have seen many firms – companies that outsource as well as outsource providers – putting in place scorecards or dashboards to “keep score” of how the outsource provider is performing. Dashboards serve as a feedback loop to help the organization involved gather data on how it is doing. If you don’t have a dashboard, think about creating one now. However, do keep in mind that using a dashboard improperly can result in one or two of the final ailments: “Measurement Minutiae” and “The Power of Not Doing.”

One technology provider we visited had so many metrics that a formal “binder” was necessary to keep track of everything each month. Company executives were embarrassed to tell us the total person-hours across all the organizations that were required to contribute to these spreadsheets. Now, this isn’t a wasted effort if the company is getting positive results from the efforts based on the improvements its staff members are making. Unfortunately our experience shows that few companies have the diligence to actively manage all of the metrics they have created.

As she pulled up a scorecard, we randomly pointed to a measure and said, “This metric seems to be in the red [their scorecards used a color-coded system in which red indicated poor performance]. When was the last time your team discussed this performance with the outsource provider?” The response? She looked us straight in the eye and answered honestly that she had no idea. She knew the company had quarterly business reviews with its “top” suppliers, but the dashboard in question was not for one of these suppliers. We went on to ask, “How rigorously do you adhere to quarterly business reviews?” She was embarrassed to say that company executives were lucky if they met with their suppliers once or twice a year.

This case of the Power of Not Doing is not unusual – many companies have fallen into the trap of establishing measures for the sake of measures, and have not thought through how they will be used to manage the business. We’ve all heard the old adage that “you can’t manage what you don’t measure,” but if you don’t use the measures you have to make improvements – you should not expect results.

A variation on this ailment – harking back to Penny Wise and Pound Foolish —involves activities that the service provider does not perform, usually linked to common perverse incentives. For example, consider that fire departments often are funded according to the number of fire calls made. Obviously, this approach is intended to reward the fire departments that do the most work. However, it may discourage them from fire-prevention activities, which are not measured or compensated (according to Chapter 5 on “Fire & Rescue” in Local Government Finance Formula Grant Distribution – A Consultation Paper, published in 2002 by the UK Department for Communities and Local Government). In an article titled “Reinvention of Health Insurance in the Consumer Era,” published April 21, 2004, in the Journal of the American Medical Association, James C. Robinson pointed to another discouraging practice: paying medical professionals and reimbursing insured patients for treatment but not for prevention discourages early discovery and increases total costs.