Governance: An Essential Component for Successful Outsourcing

By Philip D. Porter and Robin Everett, Hogan & Hartson LLP

PharmaManufacturing.com

Successful outsourcing requires “governance,” and clear management of communications, performance, change and disputes.

As the global economy becomes more competitive, companies of all sizes are considering outsourcing their non-core functions to service providers that specialize in these functions. Successful outsourcing allows a company to focus on becoming more competitive in the performance of its core capabilities and to delegate other aspects of its operations to one or more service providers who can reduce costs and improve performance in these non-core functions. However, improvements and cost reductions typically require transforming the way in which the outsourced functions are performed, and the impact of such transformation is one of the greatest challenges facing the parties to an outsourcing transaction.

Veterans of numerous outsourcing transactions recognize that the very changes that are necessary components in transforming an outsourced function inevitably create issues that are common to most, if not all, outsourcing transactions. The ability to identify and resolve these issues creates the power to manage the outsourcing transaction in a manner that both fosters the necessary changes and mitigates the issues that a transformation creates.

During the last two years, the word “governance” has become the buzzword for the most effective strategies for resolving issues that seem endemic to outsourcing transactions. Dictionaries equate governance with management and control, but like most buzzwords, governance means different things to different people. An effective approach to governance in an outsourcing transaction requires that the parties address in the outsourcing contract, at a minimum, the following four areas: communications management, performance management, change management and dispute management.

I. Communications Management

An outsourcing contract can facilitate communications management by creating procedures for exchanging information and communicating issues first within the internal organizational structure of the outsourcing service provider and the customer and then between the parties. Military chain-of-command procedures long predate outsourcing transactions but they provide a valuable model for dealing effectively with information and events. Organizations operate most efficiently when matters are dealt with at the lowest possible level in the operations and management hierarchy. The parties need to escalate any issue that is not resolved at the level where it originates, together with all relevant information, to the next higher level, where it can be processed and resolved or further escalated as appropriate. With effective internal communications procedures in place, the parties to an outsourcing contract can create, and invest in the personnel time necessary to implement, structured communications procedures between them.

II. Performance Management

The greatest performance management challenge is isolating a realistic subset of all of the outsourced functions whose performance is truly critical to the customer’s success. Once critical functions have been identified, procedures for measuring the performance of these functions must be put in place and performance standards, which are commonly referred to as service levels, can be attached to them.

In order to create an incentive for the outsourcing service provider to achieve the service levels, all outsourcing contracts must establish remedies for failure to meet service levels. The most common remedies are service credits, self-help and termination. Service credits are reductions in the fees or charges that are payable to the service provider for the outsourced services. Self-help provisions permit the customer to step in with its own personnel or outside contractors to assist the service provider in rectifying one or more performance failures or to take complete responsibility for performance in the event of a serious failure. Termination is a remedy of last resort, since transition to another service provider or return to in-house performance of the services is time-consuming and costly. Nevertheless, a customer must retain the ability to “fire” a service provider if it experiences serious and repeated service deficiencies.

III. Change Management

The parties to an outsourcing contract have a shared need for cost reliability. The customer enters into such a contract based, in large part, on the savings it believes it will achieve, while the service provider has tried to calculate carefully the costs it will incur to provide the requested services so as to preserve its own profit margin.

Two factors invariably undermine the reliability of each party’s cost calculations: scope creep and demand creation. Scope creep occurs when a customer insists that particular services that are not specifically identified in the outsourcing agreement are nevertheless service provider obligations. Such services typically relate to services that are specifically identified as service provider obligations and are often minor in nature. Demand creation occurs when a service provider seeks to increase the scope of services that the customer has outsourced, with a corresponding increase in charges. Employees of the customer may well find additional services proposed by the service provider to be appealing.

An outsourcing contract needs to include a carefully structured change management procedure with practical guidelines for distinguishing between additional services that are included in existing fees and additional services that justify additional fees. The contract needs to establish clear procedures by which service provider personnel are permitted to introduce new or additional services to customer personnel.