Increased buyer savvy paves the way for notable shifts in deal structure.

by Bob Cecil

Despite challenging conditions in financial services and other vertical markets, outsourcing demand continues to increase. And amid this growth, the marketplace is becoming more educated about outsourcing. Armed with research and observation, organizations are getting smarter in how they structure their outsourcing deals for transformation and cost savings.

That increased savvy has fueled trends in areas such as deal scope, pricing, and length, as buyers strive to align their deals with organizational metrics and build strong outsourcing relationships over time. To that end, many prospective buyers are also opting for a formal assessment of their needs before charging into the marketplace with an RFP. Trends such as these are influencing the structure of outsourcing deals for 2010.

Let’s start with scope. In contrast to the megadeals of a few years ago, FAO buyers increasingly are starting out with smaller deals, outsourcing some back-office functions with possible expansion down the road. For example, an organization may begin by outsourcing its invoice processing and bank account reconciliation, and later add financial reporting after gaining confidence in the provider and laying the foundation for a strong relationship. Similarly, deals may include a pilot, enabling parties to test the outsourcing of a process in one region for possible expansion to another.

In addition to scope, pricing models are taking on new shape. As outsourcing matures, buyers want more than transactional cost savings and service improvements; they want broader business impact. One way to support that objective is through pricing based more on outcome than on volume. For example, rather than paying for a certain number of receivables processed, CFOs might prefer to pay for an overall reduction in past-due receivables and the corresponding cash flow improvement. This trend in outcome-based pricing could lead to more sophisticated models, whereby a service provider is rewarded for, say, productivity improvements attributable to its analytical support.

Holding service providers accountable to such end-to-end outcomes does havelimitations, since a reduction in past-due receivables, for instance, may not immediately be within a provider’s full control. However, as deals mature and providers demonstrate their broader capability while buyers build trust, outcome-based pricing may become standard by 2010. A related kind of outcome-based pricing – milestone payments – is already gaining traction during the transition phase of a relationship. Instead of paying providers a set monthly price, some organizations are tying their payments to key goals along the transition timeline, such as the completion of knowledge transfer or hiring.

In addition to pricing and scope, another notable shift in deal structure is the average length, which is decreasing from seven years to five.  Except for those deals with large scale transformation, five years is proving enough time for most providers to recover their investment while buyers achieve improvements and enjoy a couple of years of steady-state operations. Another trend is increased deal renewals, along with more renegotiations of contracts prior to expiration. Fewer years and more renewals are favorable signs, showing that outsourcing relationships are working.

Add it all up, and buyers are striving for outsourcing deals that are more meaningful to management. That’s why, in a related trend, many buyers who are just getting started with outsourcing are resisting the temptation to go straight to the marketplace with an RFP. Instead, they’re researching their options through the use of formal assessments, which can be smart, cost-effective ways to get a snapshot of the current state and identify which functional areas to bid out to providers. How does a company’s cost structure compare to the marketplace? What would the business process delivery model look like with an outsourcing provider, a captive or shared services environment? What are the appropriate service levels to support the organization? To answer these questions, many buyers are working with advisory firms to assess their entire back-office organization before beginning the cost- and time-intensive RFP process.

Final Thoughts
According to an EquaTerra study conducted July through September 2007, demand for FAO and outsourcing overall is robust. While recent turmoil in the financial services industry could slow outsourcing efforts in the short term, the long-term outlook is strong as buyers strive to reduce operating costs and focus their investments on more strategic activities. Indeed, the trends in financial services suggest that outsourcing is becoming a “recession-proof” tool, helping buyers improve performance when the market is up, while reducing costs and remaining competitive when it’s down.

Whereas outsourcing in the past may have been just an option, it today is becoming a necessary consideration, as more and more relationships demonstrate its effectiveness. Organizations are clearly becoming more educated about outsourcing, and that’s serving them well as they structure their deals in more meaningful ways.