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Picking an outsourcing service provider? Avoid these four mistakes

If 2011 is like 2010, choosing the right outsourcing service provider and getting the deal off to the right start will be critical for CIOs. Here are four mistakes to avoid.

With companies being squeezed by the worst recession in decades, recent spending on outsourcing has jumped. Among organizations that outsource some IT work, the percentage of total IT spending going to outsourcing service providers was 7.1% in 2010, according to Computer Economics Inc., an Irvine, Calif., advisory firm. That’s an increase from 6.1% in 2009 and 3.8% in 2008. If 2011 is anything like the past three years, selecting the right outsourcing service provider and getting an outsourcing contract off to a good start will be critical for many CIOs. spoke with Steve Martin, partner at Tysons Corner, Va.-based outsourcing advisory firm Pace Harmon LLC, about mistakes CIOs often make when they choose an outsourcing service provider. A former partner at Deloitte Consulting, Martin has led more than 100 strategic outsourcing deals totaling $7 billion in products and services. Here are four mistakes your organization does not want to make when it puts together its next IT outsourcing deal.

Mistake No. 1: Sole sourcing, or forgoing the benefits of the competitive process

This cardinal mistake often happens when the organization has an incumbent vendor or when the CIO relies on a previous relationship with an outsourcing service provider. "A CIO comes in from another company that used an HP or an IBM and had a good experience, forgetting that the relationship was based on formal process," Martin said.

CIOs typically end up with good service because the outsourcing service provider will price its work at a level that allows for investments (in people, processes and technology) that aren't possible from a vendor selected solely on price. The downside is cost. When sole-sourced deals are benchmarked against the best market deals or against a well-run IT shop, the price comes in 30% to 40% above market rate, Martin said.

It takes two outsourcing vendors to tango to a competitive deal, even if one of them has only a 10% chance of winning.

Mistake No. 2: Focusing too much on cost

"These are CIOs who decide they are going to get the best possible deal for their companies on paper, by essentially reverse-auctioning performance," Martin said. Once the successful bidder has promised the moon to win the deal, however, that vendor's next task will be explaining to his board how this boondoggle can actually work. The solution often translates into such vendor shortcuts as removing people from the account team or even more drastic measures, he said: Your outsourcing service provider could realize it is better off walking away from the deal than continuing to lose 10% a year.

Brokering a deal that works for both sides requires understanding "what the market really is" for IT services, Martin said. That means knowing what it costs for a well-run internal IT organization to perform those services. Broad benchmarks, such as IT spending as a percentage of company revenue, won't cut it. "You need to get down to the level of what it costs for desktop support, trouble tickets, for server management, to manage your routers, and so forth," Martin said.

Next, benchmark the cost of managing those services externally. An IT outsourcing consulting firm can help you understand what the best rates in the market are for various services. "That doesn't mean you have to beat it or take it. The best rate in the market that anybody has ever seen is not going to perform well because it is so tight." Martin said.

Mistake No. 3: Disclosing too little (IT assets) or too much (performance levels), or lying

The information anchoring any outsourcing contract is an organization's IT assets: PCs, servers, routers, printers and facilities. Your organization's demographics almost always are disclosed, Martin said.

If IT operations are being managed internally, most organizations (60%) also will disclose the number of IT employees with no significant downside, in Martin's view. (The argument against disclosing personnel numbers is that the vendor will price the deal at where it thinks it needs to be to save you money, rather than at what it takes to do the business.)

Once you select a vendor, leverage shifts from "virtually 100% on your side to 70% to 80%" on the vendor's side.

Steve Martin, partner, Pace Harmon LLC

Performance levels are a different matter. CIOs should clearly define their target performance levels to a prospective outsourcing service provider, but Martin's firm advises against disclosing all their current performance levels. An outsourcing service provider that knows both how many people you have and whether you meet your performance levels also will know whether you are over- or understaffed. How your staff has performed in the past is not germane to what you are asking the outsourcing provider to do for you now.

Vendors will ask for your costs every time. Resist. Again, you are not asking the outsourcing service provider to "toggle off" your current costs, but to use its expertise and come up with a competitive price for the job.

Another downside of disclosing cost? Top-tier vendors -- Hewlett-Packard Co., IBM and CSC Corp., for example --often have strong board relations. Once they know your price, they can and might bypass the procurement process to deal directly with your organization's board, Martin said. The result could be an unnecessarily high price tag. If you are spending $80 million a year, for example, your vendor might guarantee the board it can do the job for $70 million. Your CEO or CFO might be tempted to take the $10 million and run, Martin said -- even though a well-run competitive process could put that job at $60 million.

One more word on disclosure: Some CIOs will misrepresent their current IT environment to an outsourcing service provider to game the deal, or because they don't have the systems or time to get accurate information. That leads to the fourth common mistake:

Mistake No. 4: Rushing to lock the deal

When CIOs give management a time frame for getting the deal done, the dates inevitably slip. Figuring that no one cares "how the sausage is made," organizations rush to complete the deal before removing or spelling out vendor assumptions implicit in the terms used in the agreement, or locking down key terms. Once you select a vendor, however, leverage shifts from "virtually 100% on your side to 70% to 80%" on the vendor's side.

You do not need more than two vendors to create a viable competitive atmosphere. When you're dealing with one vendor that a 90% chance of winning the bid and another that has a 10% chance, Pace Harmon advises that you keep the 10% vendor around -- and that is not simply to string that vendor along. Early low odds often are based on unfamiliarity with a vendor, rather than on anything being wrong with the bid, and the situation could change quickly: "We have seen a 10% chance become 30% and 40%," and higher as negotiations proceed, Martin said.

Some insider baseball: A top-tier outsourcing service provider recently told Martin that his company is more than happy in some situations to play the stalking horse on a deal, if the client is a good customer of another service, and knowing that the winning vendor "will be that much weaker in five years" for doing the deal.

Let us know what you think about the story; email Linda Tucci, Senior News Writer.

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