The Art of Successful Outsourcing

Four critical factors in structuring the facilities management outsourcing contract

By Rakesh Kishan and Michael Redding

Organizations outsource facilities management to gain the benefits and value associated with focusing on their core business. It enables them to access professional facilities management technology, processes and competitiveness, while reducing costs and increasing value in ways they may not have been able to the do using existing methods. It also can result in better management of their workforce and increased operational flexibility.

Yet many traditional outsourcing agreements have met with failure or, at best, “deferred” success. There are many reasons why this happens, but the occurrence of “bad deals” can be avoided. Needless to say, it always involves upfront mistakes related to the outsourcing strategy, transaction or deal structure and incentives, and the governance process.

Today, best-in-class customers take a broader view of the contracting process and customer-provider relationship. In particular, they employ four key strategies in structuring and managing the facilities management outsourcing contract:

1. A cross-functional approach to developing the outsourcing agreement
2. An incentive-based structure that places the focus of the supplier relationship on value
3. Contract provisions that give the customer more rights and the service provider more responsibilities
4. Effective ongoing governance by the customer’s retained organization.

These strategies are critical to the success of facilities management outsourcing from the customer’s perspective.

A cross-functional approach

Gone are the days when the facilities manager could take a single-handed approach to selecting a service provider and signing the contract. Traditionally, the facilities manager would attempt to write a detailed, exhaustive and prescriptive scope of work and seek bids from prospective service providers. But it is impossible to foresee and define every possible work activity—inevitably, there will be an unexpected large dead tree limb lying in the parking lot or another event that was unanticipated when the scope of work was written. Are these services covered in the scope of work? Probably no. Is it the service provider’s responsibility to remove it? Of course. Should its removal incur additional time and materials (T&M) charges by the service provider? Absolutely not.

Nevertheless, this is precisely what has happened time and again, much to the surprise and chagrin of many customers. To protect themselves, many customers develop a “shadow organization” to monitor the service provider’s staff and to make sure that they are performing their duties and billing according to both the letter and spirit of the contract. In turn, this increases the inefficiency and overall cost of outsourcing. No wonder many outsourcing deals become unsuccessful.

Within the last decade, outsourcing agreements have increased in dollar value, geographic reach, scope of services, and overall complexity. Today, it is not unusual for an outsourcing contract for a major corporation to be global in scope, encompassing services ranging from facilities operation and maintenance to a host of workplace services, and real estate financial transactions. These in turn, can approach a billion dollars in value over a typical five-year contract period. As a result, greater discipline is required in structuring the contract and governance models.

Objective performance measures have replaced line-of-sight management. Continuous improvement in the service provider’s processes and technology has become essential to delivering cost reductions. Customers are rightfully demanding greater value from the deal than just the incremental savings associated with transferring staff to the provider’s organization. And due diligence is more important than ever—both internally, in defining the scope of work, budget and performance expectations, and externally, in ensuring the service provider has the capabilities to meet those performance expectations.

That’s why today, structuring an effective outsourcing contract begins with the involvement of a cross-functional team representing the customer. Typically this team is led by the “business owner”, such as manufacturing or R&D, and includes strategic sourcing, HR, and a third-party law firm all working together to structure the agreement. They will begin by having potential service providers bid against a budget and all of the work that is encompassed by that budget rather than bidding against a scope of work. This makes the service provider responsible for understanding the scope of work and everything that it entails. Of course, there must be mechanisms identified up front to accommodate a change in the overall scope of work—for example, the addition of a new building on a campus or closure of a plant.

Incentive-based pricing

The traditional T&M contract pricing structure pays the service provider for supplying workers. That is, the service provider charges the customer an hourly fee for every technician on site, plus materials. Even though service providers are responsible for managing within a budget, they tend to try to spend to that budget limit.

Successful outsourcing agreements are structured around incentive-based contract pricing, which provides incentives for the service provider to continuously increase productivity and reduce the budget, thereby generating savings and enhancing their profit margin, while not reducing their service levels. To accomplish this, the contract should be structured so that the service provider passes through direct expenses at cost and charges a separate fixed management fee (i.e., overhead and profit). And, the management fee should be tied to the service level.

The main underlying mechanisms of the incentive-based contract are “performance driven fees” and “shared savings.” Performance driven fees tie a portion of the service provider’s management fee to service level or measurable performance, ensuring that they do not reduce budget by cutting back on service. Shared savings awards a percentage of the cost savings to the service provider, motivating them to find ways to reduce the budget.

The art is in balancing these two incentives so that service providers are best rewarded when they achieve both performance and cost reduction. In each case, this balance is achieved by using the appropriate incentive algorithms and “pay-off” scenario. In addition, caps and floors can be employed to reduce the volatility of the incentive structure. There are many ways to creatively structure these, especially in the context of integrated global deals that may include the use of structured real estate finance products and business terms to optimize risk and liability across the prime and sub-contract chains.

Customers should challenge service providers not only to beat the current year’s budget, but also to reduce the budget in successive years through continuous improvements in their processes, training, technology and other resources. This requires the customer to create both a current budget and a pro forma budget three to five years out that will project a “glide path” of achievable savings.

Customer rights/supplier obligations

Traditional outsourcing contract models tended to be slightly larger versions of the contracts that service providers were using to provide tactical services (e.g., snow removal), or they were modified project-engineering contracts. These contracts tended to create a “50/50” relationship, equalizing the customer’s and the service provider’s rights and obligations.

However, the risks for the customer are always far greater than those for the service provider in terms of disproportionate harm coming to the customer if services in plant or R&D settings are not delivered effectively—loss of experiments, manufacturing output, etc. For example, if a customer is outsourcing manufacturing maintenance and that service isn’t properly delivered, a factory may be shut down as a result. On the other hand, in most outsourcing agreements, the major risk for the service provider is loss of profit.

This is why new contract structures are giving customers more rights and service providers more obligations, for example:

• Dragnet clauses specify that all of the work that was commonly done in the last couple of years prior to outsourcing is part of the scope of work regardless of whether it is specifically identified (e.g., removing the tree limbs, etc.). These ensure that the scope of work document is illustrative instead of definitive.
• Eliminating exclusivity gives the customer the right to use other service providers to perform all or part of the scope of work in case a supplier is unwilling or unable to perform adequately.
• Pricing controls limit the ability of the supplier to produce unanticipated budget increases to the customer, while pricing flexibility clauses allow the customer to reduce or increase the budget as required to meet business mandates.
• Supplier termination clauses allow the service provider to terminate the contract for non-payment of fees only, not just for convenience, as traditional contracts have allowed. At the same time, the customer may retain broader termination rights based upon the criticality of the facility under contract. In addition, if the contract is terminated, the supplier is obligated to support a successful transition of services, either back to in-house staff or to another service provider.
• Audit rights give the customer the right to receive detailed invoicing, but if the customer is getting subcontracted services on a pass-though-cost basis, then the customer also has the right to audit the subcontractor’s service contracts to make sure they conform to the requirements under the Sarbanes-Oxley Act.

The up-front contract

Having developed the right contract, the customer should present it upfront to all potential service providers along with the request for proposals (RFP). This runs counter to the traditional process, in which the customer sends an RFP out for bids and starts negotiating a contract after all bids have been received. However, once the customer has short-listed potential service providers, the suppliers may have undue negotiating leverage, as it becomes more difficult for the customer to impose many of the contract terms that have been discussed above.

Moreover, if the customer brings the right contract document to the table up-front, service providers have the opportunity to understand contractual obligations, and price the work accordingly in their RFP submittal. Otherwise, prices get changed once the business terms are imposed.

This is why best-in-class customers go to market with both an RFP and a contract document and ask the bidders to mark up the contract as part of their submittal. As a result, service providers tend to be much more accepting of the customer’s terms. In addition, pricing is based on up-front knowledge of the contract terms. As a result, the customer receives much firmer and more comparative pricing from bidders.

Effective governance

Aside from audit rights, governance is not technically part of the contract structure but it is critical to the success of the outsourcing contract. Governance is essentially a process of optimizing outsourcing performance by effective management of the customer relationship, supplier relationship and organizational interface. And it is the proper role of a small stay-back team that includes functional experts in key areas, in particular, energy, capital planning, space planning and maintenance.

Effective management of the customer relationship ensures the services being provided under the contract support the needs of the internal customers, for example, the manufacturing operation. This requires the stay-back team to monitor customer satisfaction and changing customer needs and communicate this information to the service provider.

Effective management of the supplier relationship ensures that the commitments made by the service provider, as described in the contract (e.g., service levels, efficiency improvements, etc.), are actually being realized. This requires the stay-back team to monitor supplier performance, provide direction on any new corporate initiatives and work with the supplier to make sure new initiatives are promptly implemented. Effective organizational interface requires the stay-back team to manage the “seams” between the primary service provider, other service providers and internal co-delivery organizations.

The stay-back team should be large enough to manage these relationships, yet not so large as to constitute a shadow organization. Overstaffing not only increases direct costs, but it also creates a risk that the team will begin to take away operational control of service delivery from the service provider, which diminishes the benefits of the service provider’s best-in-class processes and technologies. The key is to have an effective open relationship that is performance focused.

Preparing for success

Employing these four key strategies in structuring and managing the outsourcing contract—a cross-functional approach to developing the agreement, an incentive-based contract structure, contract terms giving the customer more rights and the service provider more responsibilities, and effective ongoing governance—lays the foundation for a successful facilities management outsourcing relationship. Preparing for success also requires strong leadership, change management, effective training of the retained organization for the new processes and management style required by outsourcing, and ongoing relationship building between the customer and service provider.

Best-in-class customers are those who take a strategic approach to outsourcing contracting and management. They are clearly in a better position to realize all the advantages well-structured outsourcing relationships can provide.

Rakesh Kishan (rkishan@umscg.com) is Managing Director and Michael Redding (MRedding@umscg.com) is Director of UMS Facilities Consulting, a management consulting firm specializing in Performance Management, Best Practices & Outsourcing for Facilities Organizations (www.umscg.com). UMS is a wholly-owned subsidiary of EMCOR Group, Inc., a Fortune 500® leader in mechanical and electrical construction, energy infrastructure and facilities services for a diverse range of businesses globally.