BALANCING THE STAKES. Risks and Critical Success Factors for Procurement Gainshare Arrangements

Transcription

1 BALANCING THE STAKES Risks and Critical Success Factors for Procurement Gainshare Arrangements Shahid Bhatty, Principal Consultant, ISG Sue Danino, Partner, ISG

2 INTRODUCTION: THE GENESIS OF GAINSHARE IN PROCUREMENT A joint study on procurement outsourcing by Aberdeen Group in late 2007 found that more and more companies are looking into the feasibility of outsourcing their procurement functions i. For most, the main reason to look for an outsourcing partner is not only to reduce operational expenses, but more importantly, to realize potential savings from third-party spend. Companies recognize that the savings potential from labor arbitrage by outsourcing the operational/transactional aspects of procurement to low-cost countries or geographies, even though significant, pales in comparison to the potential savings generated via strategic sourcing activities. Savvy procurement professionals and company executives know, though, that it will typically cost more in the early phases of a procurement business process outsourcing (BPO) process because standing up strategic sourcing initiatives requires considerable up-front investment in terms of category experts, tools, and program management focus. In order to justify the heavier up-front investment that strategic sourcing requires, C-level executives typically ask these questions: What is the probability of generating the promised savings? (i.e., are the savings real?) What is the risk of an up-front investment? Could gainsharing be a potential mechanism for mitigating the risk of the additional investment required to implement a strategic sourcing program? The service provider community is keenly aware of the dilemma facing companies considering procurement outsourcing. The providers know well that savings drives procurement outsourcing, so during the sales cycle service providers emphasize sometimes too aggressively the savings potential and their ability to generate and sustain the said savings. At the same time, they are also cognizant of the up-front costs associated with generating those savings. Hence, most service providers are willing to discuss gainshare arrangements at the outset of any potential outsourcing transactions. i Procurement Outsourcing: A Strategic Imperative? Study conducted by Aberdeen, November BALANCING THE STAKES SHAHID BHATTY, SUE DANINO 1

3 GAINSHARE: STRUCTURE AND RISKS Procurement cost savings gainshare is defined as the allocation of achieved procurement cost savings benefits between the client and the service provider. ISG clients are invariably interested in the topic of gainshare as a means of mitigating the dual risk associated with achieving savings claims and committing to required up-front investments for strategic sourcing. They are asking us about: Components of a successful gainshare agreement in the procurement space Risks associated with pursuing gainshare Critical success factors for making this type of arrangement work ISG advisors, many of whom have previously worked for the service provider community, have both structured and implemented gainshare models for their clients and companies with mixed results. Structuring a Gainshare Agreement A well-designed gainshare agreement should first and foremost focus service provider behavior toward savings and service delivery. As such, it is critical that a gainshare agreement feature these elements, at minimum: Commitment to savings The service provider should have skin in the game by putting its revenues and profits at risk. This focuses them on savings initiatives. The exact amount at risk always has to be negotiated based on the risk tolerance of outsourcing clients and their service providers. Gainshare on realized savings only Service providers should be paid gainshare on realized or implemented savings only, as this is the real money that flows to a company s bottom line the earnings per share. Clients should make sure there is no gainshare paid for savings classified as cost avoidance. Balance risk and reward Clients may reduce their cash outlay up front. However, there should be an associated opportunity for the service provider to increase its revenue at the back end. Match cash outlay with incoming savings Based on the gainshare model, the client can fund the transaction with the savings generated in exchange for a higher payment at a later time. At the same time, the client typically gets proportionately more of the gains as they increase. Improve service delivery without diluting service levels By negotiating gainshare agreements outside of a service-level framework, individual service levels associated with delivery of service are not diluted. Risks Associated with Gainshare We have witnessed both good and bad results from implementing gainshare agreements. Even though the idea behind the gainsharing concept is to shift the majority of the risk to the service provider, in reality, both the service provider and the client may make the transaction riskier to implement and manage. These are the major risks inherent with gainshare agreements: Savings definitions and capture What constitutes savings? Defining savings may be different based on the category, and sometimes the service provider and the client may not agree on the definition. In all failed gainshare agreements, this has been one of the major issues that finally resulted in the gainshare arrangement falling apart. Savings negotiated but not realized Typically, the service provider cannot force compliance with a new agreement throughout the client s company. In some instances where the procurement outsourcing engagement is not universally accepted within the client s company, the negotiated savings never translates into realized savings. The service provider will argue that it did all the work and should, therefore, be paid regardless of whether the new program was implemented or not. If a client company agrees to this, it may end up paying a large portion of the now-reduced realized savings to the service provider as a fee. Addressable spend impacted by gainshare It is typically difficult to apply gainshare on project-based categories where baselines do not exist. This is especially true for most service type categories, such as construction, where each project may be unique and there are no baselines to reference. As noted previously, if there is no agreement on how to handle these situations and savings definitions cannot be agreed upon, the service provider may not appropriately focus expertise and resources, which can result in diluted service delivery. Focus on savings as opposed to service Because a service provider has money at risk and simultaneously maintains the potential to increase revenue/profits, it may allocate a disproportionate amount of resources and expertise to sourcing initiatives with larger savings potential. This comes at the expense of ignoring the BALANCING THE STAKES SHAHID BHATTY, SUE DANINO 2

4 smaller categories that may have more strategic impact on a company s performance. Allocation/accounting of gainshare It is sometimes difficult for a client s business units to agree on how to allocate the gainshare back to the service provider. CRITICAL SUCCESS FACTORS IN A GAINSHARE AGREEMENT Given the complexities outlined above, gainshare agreements work best when there is a commitment to the relationship starting at the corporate executive suite and continuing all the way to the operational teams. The client relationship owners need to be actively involved in the management and governance of the client/service provider relationship. And it is best to get the service provider s salespeople out of the process early on so that concerned stakeholders can build and sustain the working relationship. From a client perspective, the service provider cannot work in isolation. It is vitally important that the client relationship owner help identify and implement initiatives to ensure that both parties gain the maximum benefit. The commitment from the service provider should be equally strong in terms of investing the optimal level of resources to implement sourcing initiatives. A strong governance framework needs to be implemented before the onset of the gainshare engagement to facilitate a collaborative and transparent relationship. Both parties should clearly understand the costs, risks and rewards of pursuing this path. The governance framework should have clearly defined procedures for issue resolution and escalation to allow both parties to efficiently work through issues inherent in a gainshare agreement. The biggest area of disagreement between clients and their service providers will always be how to measure and capture savings. In order to reduce friction in this area, the process of measuring savings should be based on generally accepted accounting principles, to the extent possible, allowing for internal and external audits. Interests of both parties must be aligned and meet client business objectives. The savings generated should never be detrimental to the level of service provided. And from a service provider perspective, the reward should be proportional to the risks. CONCLUSION The challenges of designing and implementing gainshare agreements are highly complex. Factors include a client s relationship with potential service providers and the nature of the client organization and culture. Clients considering gainshare arrangements should be fully aware of the potential risks associated with such agreements but also should take into consideration the potential advantages. If implemented correctly, gainshare can be a workable mechanism to create a sustainable partnership with a service provider in the procurement space. BALANCING THE STAKES SHAHID BHATTY, SUE DANINO 3

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6 APPENDIX GAINSHARE MODELS Generally speaking, there are three types of gainshare arrangements; but in reality one can have a large variety by mixing and matching various elements of these three models. 1. Base Deal Plus Contingency This type of agreement involves billing wherein the client pays full price. There is an annual gainshare bill based on percentage of savings above the servicelevel threshold. The salient features of this type of agreement are: Service provider commits to a savings threshold Gainshare is achieved only on excess savings versus cost avoidance Least amount of risk is incurred by both service provider and client. The provider still gets its full fees and incurs only service level-based penalties on minimum savings not achieved. The client receives the minimum savings per service levels, with any savings over and above threshold as a bonus. Deal is service-level-driven; however, having a large portion of the at-risk amount allocated to savings service levels may dilute delivery performance service levels 3. Total Gainshare This type of agreement involves monthly billing based on the service provider s cost of delivering the service. There is an annual/semiannual settlement based on savings achieved. Other aspects of this type of agreement include: Typically a base fee covers service provider s cost Even though gainshare percentage is typically the highest to cover service provider risk, there also are caps on how much gainshare the service provider can attain Savings-related service levels are not included Savings is the only critical service level Performance-based service levels are measured, but it is extremely difficult to apply any sort of performance credits Service provider s strongest incentive to achieve savings is that the provider is taking on most of the risk The agreement may be risky for the client because there is no contractual guarantee of savings 2. Percentage of Fees at Risk This arrangement involves reduced monthly billing at a negotiated percentage, such as 90 percent of full price. Both parties settle annually based on savings levels achieved. The main features of this type of agreement are: No savings-based service levels that elevate the delivery performance service levels Significant increase, in practice, to the at-risk amount Higher risk to the service provider and, therefore, much higher motivation to achieve the threshold savings BALANCING THE STAKES SHAHID BHATTY, SUE DANINO 5