Your sourcing model can make or break the deal
Author: Kate Vitasek, Faculty, University of Tennessee
Whether a company is looking to outsource a non-core function across the street or across an ocean, choosing the right sourcing model is crucial: it will make or break the deal. Seven key models along the sourcing continuum, from approved supplier to equity partnership, are examined in this article.
Progressive companies and their suppliers are looking beyond typical transaction-based procurement models for their sourcing needs. This is because outsourcing today is not a simple make versus buy decision, especially when it comes to complex strategic business relationships: it's a continuum.
Outsourcing – a transaction or a relationship?
Unfortunately virtually all businesses use the same transaction-based approach for procuring strategic services (including outsourcing) as for buying more simple commodities and supplies. Most complex outsourcing efforts tend to be conventional agreements with detailed transaction level pricing on a per headcount or per business task basis (for example, cost per warehouse pallet stored, per minute of call, or per IT server).
But a transaction-based approach is not necessarily the best basis for every business and sourcing relationship. For simple transactions with abundant supply and low complexity, a transactional model will likely be the most efficient way to go. The real weakness of this approach emerges when things are more complex, with variability, mutual dependency or customized assets or processes. A transactional approach cannot produce market-based price equilibrium in variable or multi-dimensional business agreements: other approaches are likely to be more appropriate.
Outsourcing choice determines how you do business
Companies looking to outsource will generally go through a rigorous make-versus-buy decision process. A key factor typically revolves around whether the function at issue is a core competency, where performing the work “in-house” would provide a competitive differentiation. Unfortunately, it is virtually impossible for a company to be good at all activities and these inefficiencies drive up costs. At the other end of the continuum, companies that do choose to outsource typically go to the open market, where market forces determine not only price but how companies will do business.
The “open market” mode assumes that free market forces incentivize suppliers to compete on low cost and high service. There is also an absence of dependency; if buyers or suppliers are not happy, they can move on with relative ease. Governance of the supply base is typically achieved by switching suppliers or customers if a better opportunity emerges. As a result, the market approach can rely purely on classical contract law, with little administrative control.
Beware the double “no-win” scenario
The decision along the insource versus outsource hierarchy is rarely cut and dried, however. Although each approach offers advantages, a double “no-win” scenario emerges for companies that want to drive innovation and create a competitive advantage, yet still want to outsource a particular activity. This occurs when companies using conventional arrangements find their service providers may be meeting contractual obligations and service levels, but are not driving innovations and efficiencies at the pace they would like to see. Suppliers argue that investing in their customer's business is risky because buyers will simply take their ideas and competitively bid the work. Companies want solutions to close the gaps, but they do not want to invest in people, processes and technology where they do not have a core competency.
Because of the transaction-based way they have structured their relationship, they are at a crossroads, with both buyer and service providers wanting innovation – but neither wanting to make the investment. Thus, a hybrid approach may be best suited to such a situation, where complex services have a high level of dependency, suppliers cannot be changed freely and an insource solution may not be a good fit.
Companies using a hybrid approach have a number of different ways to create strategic and longer-term relationships with suppliers that can offset the weaknesses of a pure market or insource-based approach. This hybrid approach is based on research by the University of Tennessee and known as Vested, because the both parties are committed to collaborating on the best sourcing solution.
Seven sourcing models examined
Research by the IACCM has found that most companies currently operate under conventional transaction-based models that are constrained by a formal, legally oriented, risk-averse, and liability-based culture.1
The seven sourcing business models span the continuum of the make-versus-buy decision. It is important to use the right tool for the job. Figure 1 is a quick overview. The University of Tennessee, SIG, IACCM, and CORE white paper describes each model in detail, and the complete white paper is available as a free download at the Vested website.
Figure 1 shows how the sourcing business models relate to each other along the sourcing continuum.
Basic provider model
The basic provider model is a transaction-based economic model, where there is typically a set price for individual products and services for which there is a wide range of readily available, standard market options, with little differentiation in what is offered. This model is best suited to a situation where there are low cost, standardized goods and services in a market with many suppliers. Buyers typically use frequent competitive bidding (often with pre-established e-auction calendar events) and there is little or no impact to the business when switching suppliers.
Approved provider model
An approved provider model is also a transaction-based approach, with goods and services purchased from suppliers that meet a pre-defined set of qualification characteristics, quality standards, previous proven performance or other selection criteria. Frequently organizations have a limited number of pre-approved suppliers for various categories from which buyers or business units can choose. In these transactions risks and costs are known or are relatively low. Multiple suppliers mean costs are competitive, and one firm can easily be replaced with another if the supplier fails to meet performance standards.
Preferred provider model
A key difference between the preferred provider and other transaction-based models is that the buyer has made the strategic choice of moving to a more strategic relational approach. Buying companies seek to do business with a preferred provider to streamline their buying process and build longer-term relationships with key suppliers. They often enter into multi-year contracts using a master agreement that allows them to conduct repeat business efficiently. It is important to point out that the preferred provider model is still transactional, but the way the parties work together and efficiencies achieved go beyond the simple purchase order.
Performance-based/managed services model
A performance-based model is generally a longer-term formal supplier agreement that combines a relational contracting approach with an output-based economic model, based on a supplier's ability to achieve pre-defined performance parameters or savings targets. Performance-based agreements shift thinking away from activities to predefined outputs or events. Some companies call the results “outcomes,” but in performance-based agreements the meaning of “outcome” is well-defined as the achievement of an event or deliverable that is typically finite in nature and is therefore easily understood. A good example of an output is a supplier's ability to achieve pre-defined service level agreements (SLAs).
Vested business model
A Vested business model is a highly collaborative sourcing business model where the buyer and supplier have an economic vested interest in each other's success. A Vested sourcing business model combines an outcome-based economic model with the Nobel award-winning concepts of behavioral economics2 and the principles of shared value.3
Using these concepts, companies enter into highly collaborative arrangements designed to create value for the buyer and supplier above and beyond the conventional buy-sell economics of a transaction-based agreement. A Vested business model is best used when a company has transformational or innovation objectives that it cannot achieve by itself or by using conventional transactional sourcing business models (basic provider, approved provider, preferred provider) or a performance-based agreement.
Shared services model
A shared services model is an internal organization based on an arms-length outsourcing arrangement. Using this approach, processes are typically centralized into a “shared service” department or organization that charges members for the services used. Organizations use this model for a variety of functional services such as human resources, finance operations, administrative services (such as claims processing in health care).
If an organization does not have adequate internal capabilities to acquire mission-critical goods and services, but does not want to outsource or invest in a shared services organization, it may opt to develop an equity partnership. Equity partnerships create a legally binding entity, and take a number of different legal forms, from acquisition of a supplier or creation of a subsidiary, to equity-sharing joint venture.
As companies strive to transform their operations by outsourcing, or seek higher levels of innovation from their suppliers, they need a clear understanding of their business environment and the various sourcing business model options available. It is important they align with their suppliers and pick the right model for the right environment, the right approach for the right job.
The bottom line: outsourcing today is more than a make-buy decision, it is a continuum. Sourcing, contracting or outsourcing professionals need to understand their business environment and use the right sourcing business model to best accomplish their objectives.
This article is based on the Unpacking Sourcing Business Models: 21st Century Solutions for Procuring Services white paper, the result of a collaborative effort by the University of Tennessee, the Sourcing Interest Group (SIG), the Center for Outsourcing Research and Education (CORE), the International Association for Contract and Commercial Management (IACCM) and industry and academic leaders who want to improve the way companies approach procurement and working with outsourced service providers.
Stay tuned for Kate's next article that will explore the 'how' of matching your sourcing models to the appropriate business models and their implementation.
1 “Contract Negotiations Continue to Undermine Value,” IACCM's Ninth Annual Top Ten Terms Report, April 2010.
2. Behavioral economics is the study of the quantified impact of individual behavior or of the decision makers within an organization. The study of behavioral economics is evolving more broadly into the concept of relational economics, which proposes that economic value can be expanded through positive relationships with mutual advantage (win-win) thinking rather than adversarial relationships (win-lose or lose-lose).
3. Shared value thinking involves entities working together to bring innovations that benefit the parties - with a conscious effort that the parties gain (or share) in the rewards. Two advocates are Harvard Business School's Michael Porter and Mark Kramer, who profiled their “big idea” in the January–February 2011 Harvard Business Review magazine. The article states that shared value creation will drive the next wave of innovation and productivity growth in the global economy. Porter is renowned for his Five Forces model of competitive advantage. Due to his prominence, it is likely that his take on shared value, although focused on society, likely will cause practitioners to embrace shared value approaches.
ABOUT THE AUTHOR
Author, educator and business consultant, Kate Vitasek is an international authority for her award-winning research and Vested® business model for highly collaborative and strategic relationships. Kate has appeared on Bloomberg radio, CNN, NPR and on Fox Business News. Her work has been featured in over 300 articles in publications like Forbes, Chief Executive Magazine, CIO Magazine, The Wall Street Journal, Journal of Commerce, World Trade Magazine and Outsource Magazine. To learn more about her, click on her website.