Indirect procurement outsourcing deals may seem like other standard outsourcing deals, but don’t be fooled by similarities. Indirect procurement is different and requires unique contract terms.

by Rebecca S. Eisner

Indirect procurement outsourcing is growing roughly 30 percent a year, according to the Everest Research Institute. The number of stand-alone procurement deals is increasing, and many other outsourcing deals—including finance and accounting and IT outsourcing—contain some aspects of indirect procurement. These transactional services include converting requisitions into purchase orders, and managing vendor catalog information and accounts payable services.

Indirect procurement outsourcing deals share many common business and legal issues with other outsourcing transactions with some unique differences. Pricing, savings commitments, remedies, warranties, responsibility for third-party performance, and concern about intellectual property rights are a few distinctions.

• Pricing Structures. Outsourcing services are often priced according to baselines (units of service for a baseline price), with a unit charge or credit for increases or decreases in volume. Baseline pricing may be applied in activities that are repetitive or transactional in nature (for example, the number of purchase orders handled).

• Benefits. In other outsourcing deals, most customers expect to receive the same or better services while saving on costs. Cost savings are measured by the amount that the customer pays the provider for the services. This is often not the case for indirect procurement outsourcing. While an indirect procurement service provider may in fact save the customer money, often the customer is more concerned about reducing third-party spend.

• What Counts Toward Cost Savings. Savings based on volume consumption models are relatively easy to track. If you spend $100 to turn 1,000 requisitions into purchase orders, and the procurement service provider can do the same work for $85, you save 15 percent. Tracking, measuring, and reporting cost savings on third-party spend can be challenging. The methods must be well-negotiated and documented. It is important for the customer to socialize its own internal cost savings and productivity programs with the provider, and to integrate them into the agreement with the provider.

• The Promise (and Commitment) of Cost Savings. Unlike other outsourcing deals, the potential of cost savings on third party spend in indirect procurement outsourcing deals far exceeds the value of the procurement services purchased. Cost savings on third party spend can run in the millions to hundreds of millions of dollars. Since most providers will not guarantee those savings dollar for dollar, it is important to structure the agreement so that the provider has incentives to achieve cost savings. Service levels and credits are one way to do this.

• Remedies for Failed Expectations. What happens if cost savings do not materialize? The customer and provider need to address this topic, and set reasonable rights and remedies in the agreement. When defined expectations are not met, the customer may want to consider terminating the deal. In other outsourcing deals, termination rights are often linked to the quality of service. For example, a customer may be able to terminate for repeated service level failures, in addition to general material breaches.

• Warranties. With most outsourced services, the most important warranties on services and deliverables come directly from the provider—the one with whom the customer has the contract. In indirect procurement outsourcing, providers sometimes buy goods and services for the customer under the provider’s own volume buying arrangements. Such arrangements can yield important cost savings, but they create issues regarding warranties, liability, and indemnities for such goods and services. If the provider will use its own contracts to purchase goods and services on behalf of the customer, the customer must understand the extent to which the provider can pass on warranties and other contractual protections.

• Responsibility for Third-Party Vendor Performance. Mistakes, errors and disputes are common occurrences in managing third-party vendors. The contract must clearly address the extent to which the provider will be liable—from payment disputes to late or defective shipments. For example, a procurement provider may be responsible for placing an incorrect order, but may not be responsible for failure by the third-party vendor to ship properly ordered items (unless the provider somehow caused this problem).

• Intellectual Property (IP) Rights. Determining intellectual property rights of the customer and the provider is not the first thing that comes to mind in structuring a procurement outsourcing relationship. However, it should not be the last. Success with outsourcing indirect procurement activities requires considering all of the competitively sensitive buying data that the provider will have access to and (in some cases) will control. The agreement should cover appropriate confidentiality and use rights (including addressing whether the provider may use customer data on an aggregated, no-name basis). If the provider is also using its systems, the agreement should cover customer license and use rights, including post-termination rights.

Finally, most deals include development of a procedures manual to capture processes used by the customer to run its business and to describe how services are provided. The customer should clearly define what rights it has to this manual after the deal is terminated.

Like other outsourcing deals, indirect procurement outsourcing can contribute significantly to a company’s cost savings. Structuring the deal with care will increase the chances that those savings do indeed drop to the bottom line.