Trends in Outsourcing Emerging From the Great Recession

By Diana J.P. McKenzie and Matthew C. Henderson [1. Diana J.P. McKenzie, Partner and Chair, Information Technology and Outsourcing Practice Group, Hunter, Maclean, Exley, and Dunn, P.C.,; and Matthew C. Henderson, Counsel, Information Technology and Outsourcing Practice Group, Hunter, Maclean, Exley, and Dunn, P.C.,] Approximately ninety percent of companies cut costs in 2009.[2. Pricewaterhouse Coopers 13th Annual Global CEO Survey] In the midst of a global recession, who could blame them?  In many cases, it was the cost of survival.  Outsourcing providers hoped for a surge.  In their view, what better way to cut costs than to outsource non-core business functions?  Outsourcing providers were disappointed.  Instead of a surge, many companies put outsourcing plans on hold and re-negotiated existing contracts with outsourcing providers at lower prices, in exchange for contract extensions and other trade-offs, such as adjustments to service levels.

Increased Contract Renegotiations

Over half of the companies in the outsourcing market saw increased contract renegotiations in 2009, primarily caused by the recession.[3. A dozen danger signs that your outsourcing contract is on the rocks] Information technology outsourcing (ITO) started the year slowly, but finished strong, with $56 billion in total contract value, and the strongest fourth quarter since 2003.[4. The TPI Index: An Informed View of the State of the Global Commercial Outsourcing Market Fourth Quarter and Full-year of 2009] Business process outsourcing (BPO), however, ended the year with a total contract value of $18.5 billion, the lowest since 2001.[Id.] Most industry commentators attribute the disparity between ITO and BPO in 2009 to the traditional ability to cut costs more quickly through ITO than BPO.  Despite the dismal performance of BPO in 2009, industry consultant Technology Partners International (“TPI”) reports that the market hit bottom and turned up in the second half of 2009.[Id.]

Other sources seem to support TPI’s conclusion.  A survey by consultant Gartner found that over 85 % of companies plan to maintain or increase their spending with outsourcing providers, with the vast majority of those surveyed believing the economy has recovered or will do so in 2010.[7. Gartner Survey Shows 85 Percent of Organizations Anticipate Spending on External Service Providers Will Increase or Stay the Same When Economy Recovers] Also, though cost-cutting remains a top-five priority, companies are shifting their focus from cost cutting to revenue growth.[8 Mark Raskino and Jorge Lopes, Early Findings From the 2010 Gartner CEO and Business Executive Survey (Dec. 9, 2010), available at] Many outsourcing providers hope that outsourcing plans put on hold the last couple of years will come to fruition in 2010 and 2011, especially with regard to BPO.  In addition, approximately 422 outsourcing contracts worth a total of $15 billion will be up for renewal this year, which is 40% higher than 2009.[9. TPI, The TPI Index: An Informed View of the State of the Global Commercial Outsourcing Market Fourth Quarter and Full-year of 2009] Many of those are large contracts that will likely be broken up into smaller deals.  The trend in 2010 seems to be toward a higher volume of contracts for smaller contract values, with shorter turn-around times.  Also, with signs of an improving economy, buyers that have not renegotiated existing contracts may be racing to do so, as the window may be closing on opportunities to renegotiate existing contracts for better pricing.

Lessons Learned

So what have we learned from this recession?  How has it impacted existing outsourcing arrangements and how will it impact future outsourcing arrangements?

Buyers have been trending toward reasonably-priced service providers that specialize in providing specific services.  In some cases, this has led to multisourcing.  Of course, larger providers have reacted by increasing their menu of available services, by either developing expertise in-house or, more commonly, by purchasing smaller companies that have already developed the requisite expertise.  With larger providers, buyers tend to enter a master agreement with schedules for the various specific outsourced services.

Buyers are also entering into negotiations with a better understanding of the potential that an outsourcing arrangement could fail.  In 2000, Dun & Bradstreet reported that twenty-five percent (25%) of outsourcing arrangements failed after two years, and fifty percent (50%) of them failed after five years.[10. Dun & Bradstreet Survey Finds 50 Percent of Outsourcing Relationships Worldwide Fail Within Five Years; Principal Cause is Poor Planning for New and Evolving Business Process, Business Wire (Feb. 24, 2000), available at] The flip side of the realization of the likelihood that an arrangement may fail is the realization of the effort it takes to make an arrangement succeed.  Therefore, contracts are changing to require more substantive meetings and information exchange before bidding, during negotiations, during transition and implementation, and post-implementation.

In addition, buyers are planning for the potential that different regions of the world may emerge from the recession at different rates.  With the erosion of India’s dominance in the outsourcing industry over the last few years, buyers have more options in outsourcing destinations.  China, as many predicted, has been increasing its share of the outsourcing market through 2009 and into 2010.[11. Paige Holden and Dave Miranda, Competition and Government Regulation Challenge Tech Sector Funding, According to BDO CFO Survey (Feb. 16, 2010), available at] Likely supported by the rise of “nearshoring” in the United States, Latin America’s share is also increasing significantly.[12. Id.] The Philippines is rapidly gaining on India in the BPO market.[13. Living Smartly, Indian BPO Sector Loosing Market Share (Jan. 7, 2010), available at]

The prevailing view on global economic recovery is probably that popularized by Sir Martin Sorrell of WPP, which holds that the world will emerge from the recession in a L-U-V-shaped recovery, with Europe rumbling along near the bottom of the recession for a little while, the United States emerging in a faster U-shaped curve, and Brazil, Russia, India, and China (and other less-developed nations) emerging in an even faster V-shaped curve.

Outsourcing Contract Clauses

The fact that economic recovery is so unpredictable and likely to be variable throughout the world requires contracts that can adjust to the circumstances.  Currency fluctuations alone could drastically affect outsourcing costs.  Contracts with multi-national vendors should include provisions allowing the buyer to transition its work to one of the provider’s offices in another nation at little or no cost.  Contracts should also contain carefully considered disentanglement and termination clauses.  Disentanglement clauses typically require providers to assist buyers in transitioning the outsourced functions in-house or to another provider.  Termination clauses typically allow either party to terminate for breach, and the buyer to terminate for convenience, with varying negotiated consequences.  Termination clauses also will usually include provisions that allow for termination in the event of a change in control, something that is particularly relevant given the recent consolidation and acquisition activity in the outsourcing industry, such as Xerox’s purchase of Affiliated Computer Services, Inc., Aon Corporation’s acquisition of Hewitt Associates, Inc., and PricewaterhouseCoopers, LLP’s purchase of Diamond Management & Technology Consultants, Inc.

Outsourcing contracts are also trending toward fewer service levels with more flexibility.  One popular trend is to allow buyers to re-distribute the financial weight allocated to each service level on an annual basis.  So, for example, an agreement with three service levels may have the following distribution in Year 1: Service Level 1 - 20%, Service Level 2 - 30%, and Service Level 3 - 50%.  At the end of the year, if the buyer decides it would be more prudent to focus on Service Levels 1 and 2, it may have the following distribution in Year 2:  Service Level 1 - 40%, Service Level 2 - 40%, and Service Level 3 - 20%.  Flexible contract clauses, such as those described above, allow buyers to adjust priorities for improved returns on their investments with providers.

A final item that is becoming more prevalent in the United States (and arguably throughout the world) that significantly impacts outsourcing contracts is increased regulation.  Who bears the risk of new laws and regulations implemented during the term of the outsourcing agreement?  Buyers should study the trends in their industries and carefully consider the potential for new laws and regulations that may affect their outsourcing contracts, then negotiate the allocation of risk for the cost of compliance in their agreements.

In sum, all indications point toward more outsourcing contracts in 2010 and 2011.  Hopefully, buyers and providers will enter these contracts with better perspectives gained through difficult economic struggles.  As the old proverb says, a smooth sea never made a skillful mariner.