Written by Kit Burden

“Innovation” is a word that is heard with increasing frequency in outsourcing circles, despite the concept being not exactly new. This begs the question why it has now crept its way up the list of topics for consideration in respect of outsourcing engagements, and what it actually consists of in practice.

The Oxford English Dictionary defines “to innovate” as to make changes in something established, especially by introducing new methods, ideas or products, but I doubt that most participants in the outsourcing market would classify “change” per se as being commensurate with innovation.

Change in the context of outsourcing is (to borrow from Benjamin Franklin) as certain as death and taxes, and will usually, if not invariably, be the subject of a detailed change control regime and/or schedule in the contract in any event.

So clearly there is more to innovation than simply doing things differently than how they were done before. Customers (and for that matter service providers too!) would no doubt immediately add the requirement that things be also “better”. But better how?

While there are honourable exceptions, “better” in recent times has been invariably synonymous with “cheaper”. In other words, to innovate becomes code for finding ways to provide greater volume without charging more, or to provide the same volumes but charging less. This may be (but is not necessarily) enabled by investments in new technologies or processes, or it could be a result of increased efficiencies or productivity on the part of the personnel engaged in the provision of the services.

Given the impact of the recent recession and in particular the pressure placed on corporate budgets, the intimate connection between innovation and cost reduction is understandable, and perhaps even inevitable.

However, it is also unnecessarily limiting from a customer perspective; having a service provider innovate in a way that will ultimately augment its own services to its end customers may have a far greater pay-off than simply finding a way to strip out some proportion of the fixed or recurring charges otherwise payable under the outsourcing agreement. On the other hand, such projects or changes can be harder to articulate and/or to track in terms of success or impact, and accordingly somewhat harder to create a business case for.

Regardless of what the drivers for innovation might be, the market statistics suggest a degree of scepticism as to whether it is actually being delivered as part of “normal” outsource services. In a recent survey conducted by HfS Research in conjunction with KPMG, it was noticeable that the areas classified as having evidenced “mediocre” performance were significantly aligned with activities that one might associate with innovation, such as:

  • improved analytics to improve operations;
  • transformed/reconfigured processes;
  • access to new technologies; and
  • better cloud-based delivery of services.

So is innovation a will-o’-the-wisp, never to be achieved in practice? Clearly this should not be (and is not in fact) the case. However, there must be a recognition that several factors will need to be aligned if innovation is to become a reality as opposed to mere aspiration, as follows:

A business need

It may seem trite to state, but the customer must genuinely want or need to innovate. Why? Because innovation may very well involve additional cost, potential disruption, degrees of risk with regard to implementation, and the uncertainty which is inevitably associated with any kind of change…. all of which go contrary to the concept of a “no noise” transition of service responsibility and ongoing provision of an outsourced service!

Executive buy-In

Linked to the business need on the customer side is a requirement for executive-level buy-in, particularly if there is a need to hold firm against short-term gripes from end users as the underlying transformational activities are effected (e.g., if service levels are being impacted in the meantime).

However, one must not overlook the requirement for executive-level support on the service provider side too. Innovation may involve embracing new technology or service delivery models or undertaking new kinds of activity, which carry delivery/implementation risks (and potential contract sanctions), which may not be immediately attractive for the service provider. It may therefore need a more senior executive to take a longer term view vis-a-vis the wider long-term relationship with a particular customer, and/or investments in the service provider’s wider service delivery capabilities and competitiveness.

An appropriate contract framework

Many outsourcing contracts contain provisions that touch upon innovation in some way, even if not directly. For example, a contract may include:

  • obligations upon the service provider to seek out opportunities for “continuous improvement” of the services;
  • technology refresh obligations;
  • automatic SLA adjustments to reflect improvements in service level performance evidenced as having been achieved over a set period; and
  • price/service level adjustment provisions following the undertaking of a benchmark review.

However, these provisions do not really have innovation at their core, nor do they truly create an incentive for either party to get behind an innovation agenda.

Other contracts pay additional lip service to innovation by including “gainshare” provisions. A typical provision might then invite the service provider to submit proposals as to how the services might be improved/made cheaper, on the basis that the parties would then agree (perhaps on the basis of a pre-set mechanism) how any associated costs and any downstream benefit would be shared between them.

While such clauses can look good on paper, they rarely seem to achieve much in the way of innovation in practice. One can speculate as to why this appears to be the case, but a large part of the reason is likely to be that the average customer is simply seeing the result of its own contracting approach; it will likely have negotiated hard to get the best price and service levels it can, and the comfort blanket of robust contractual remedies if the contract is not performed in accordance with its requirements.

So far so good. However, the customer should not then be surprised to find that the typical service provider will focus hard on delivering the “business-as-usual” services as required and so as to both avoid the contract sanctions and to maintain its required profit margins, rather than “chasing the rainbow” of potential innovation projects which (a) the customer might not approve anyway, and (b) may involve additional implementation risk.

How then might this be addressed? Clearly the contract would need to provide some additional incentivisation for the service provider to make innovation more of a priority rather than an afterthought. The “stick” element of such an incentive may therefore include an actual commitment on the part of the service provider to identify and thereafter deliver a minimum value in terms of innovation-related cost savings in a given period (e.g., over a calendar year), on the basis that if it fails to do so, some or all of the delta between the target and the savings actually achieved must be paid to the customer by the service provider.

This obviously looks great from a customer perspective, but may then be difficult to negotiate in vanilla form with the service provider. This is then where the “carrot” side of the incentive regime will likely need to come in. Put simply, the greater the potential risk to the service provider for any underperformance against the target, the greater in turn that it will expect to receive in terms of a percentage share of any upside. So, there will likely be cases where the majority of any benefit will remain with the service provider rather than flowing back to the customer.

Regardless of the model chosen, the contract will then need to address a number of other potential issues; including:

  • how will the “benefit” be determined? In an ideal world this may be a simple question of maths (e.g., the cost of five FTEs when previously there had been seven) but this will not always be the case;
  • how can the parties ensure that initial benefits are not just delivered in the short term but then maintained thereafter? For example, if a gainshare benefit is tied to the adoption of a (cheaper) cloud-based solution, what happens if the cost of that solution increases in an uncontrolled matter thereafter, or the solution fails/provider goes out of business?;
  • what happens if the service provider comes up with an innovation proposal which – if successfully implemented – would enable it to meet or even exceed its minimum target, but the customer then declines to approve it? The service provider might then argue that it should be “deemed” to have delivered a substantive proportion (or all) of the associated benefits, but the customer will wish to argue hard against that (i.e,. on the basis that the targets might otherwise be too easily circumvented by the service provider bringing forward proposals with massive potential benefits, but with far too much attendant change and/or risk);
  • what happens if the customer fails to support the implementation of the activities necessary to effect the transformation/innovation in question? e.g., is this a contract breach, or is it brought within the “relief notice” mechanism, which is now common in major outsourcing transactions?; and
  • what is the governance process to be followed in terms of the submission, consideration and approval/rejection of innovation proposals?

It should also be noted that the structure above works best when innovation remains synonymous with cost reduction. Additional thought and process would need to be given to any innovation proposals that would not reduce cost but would instead improve service.

Overall, therefore, one should not write off innovation in outsourcing simply because of the somewhat rocky record of delivery of true innovation to date.

Technology is changing with ever increasing rapidity and the growing sophistication of cloud-based solutions in particular will undoubtedly lead to replacement of ever greater proportions of “traditional” outsourced services and related infrastructure, with related opportunities to innovate in the ways in which such cloud solutions are incorporated into service delivery models.

The key then will be to ensure that the “building blocks” for a proper innovation strategy as set out above are in place, and that the parties have created a contract structure that will genuinely facilitate innovation, rather than just pay lip service to it.

Kit Burden is partner and global co-chair of technology sector at law firm DLA Piper.