The modern outsourcing contract

The structure of outsourcing and managed services deals has altered radically, leading to a major shift in the balance of power between contractor and customer. Guy Matthews investigates the implications.


As telecoms players with a managed services offer can hardly have failed to notice, today’s outsourcing contracts tend to be not only shorter but more flexible and fluid than those of a few years ago. The impact of which is being felt at many levels.

An increasing unwillingness to commit to long-term outsourcing arrangements in favour of short-term or ‘on demand’ contracts can be attributed in part to the effect of so many economies around the world stuck in recession, or recovering at a painfully slow rate. Confidence in what future requirements may or may not be is low, and cash is tight.

The growing popularity of cloud-based services is further fuelling a ‘pay-as-you-go’ culture, and militating against the stable, long term outsourcing relationships that used to be the norm across the telecoms world.

“We used to provide a customer with a rack for a period of time, and we got paid for that up front,” says Andreas Hipp, CEO of global carrier’s carrier Epsilon.

“Now that same customer wants it as a service. They expect a lot beside that as well. They are looking for redundancy, which means the necessity of spending on infrastructure. There are some providers of this sort of service – not us I’m glad to say – who are going to struggle with the funds needed to do that, and get the right sort of return on investment to make it worth their while.”

Jack Zatz heads the managed services portfolio for Alcatel-Lucent, and he too bemoans a culture that makes it tough for outsourcers to deliver on what customers want, and be sure of ending the deal in the black: “It’s difficult to make margin where you are asked ‘I want like for like, but for less’,” he says.

“You are told as an outsourcing provider that the customer wants 20% savings on the way they were running it themselves, and you’ll need 20% for yourself, so it’s got to be done 40% cheaper, which in many cases is impossible, unless the customer was doing it very inefficiently before.”

Andreas Kederer, director of product management for managed services with Colt, says the company has been signing notably fewer long-term contracts in recent years: Four years ago, it was natural to have three years as the absolute minimum length of contract, going up to 10: “Customers now want to have services that follow their needs, rather than paying for a lot of capacity and hoping they can make synergies out of it,” he says. “We’re in a short-term era, where customers want to commit to two years, or fewer.”

Kederer cites the instance of a European insurance group that recently approached Colt, looking for help with consolidating its accounting function, something that would once have been supplied over a multi-year period: “They asked us to supply capacity as they needed it,” he recalls. “The customer will often ask for flexibility in this way, but as a supplier you have to ask if you want to give them what amounts to a private cloud for the price of a standard service. Where’s the margin for you? If you are selling something dedicated and bespoke from the start, then the pricing reflects that. There’s got to be a balance here.”

Short-term contracts in it for the long term?

If outsourcers are under immediate pressure from this reordering of priorities, who are the longer term winners and losers in this more-for-less environment, and how is the pricing of managed IT and communications services set to evolve as we look to the future?

Both the telecoms industry and business world are growing accustomed to an ‘on demand’ business model, for the acquisition of everything from infrastructure to applications and software, but the jury is out on who the ultimate gainers are.

At first pass, a ‘pay-as-you-go’ model may favour the buyer, as it provides a high level of flexibility, with the least amount of forecasting needed. Buyers do not need to know what they are consuming, they can just use it as they please.

The flip side of this flexibility is that over time, reporting and monitoring become more and more critical to ensure that value is still being felt. The matter becomes ‘Is the solution being implemented still the most efficient solution?’ As the volume of resources consumed increases, is a ‘pay-as-you-go’ model still cost effective, or is there a tipping point beyond which a more committed form of acquisition starts to look like better value?

Providers of outsourcing are of course under pressure themselves – tasked with responding proactively to changed costing and pricing methodologies, where necessary moving their whole cost structure, currently allocated to a committed usage model, to one with a more favourable recuperation of costs based on flexible commitments.

This probably means a model where users must pay a premium for flexibility, or pay a higher per unit price for smaller increments of service. For a buyer with knowledge of their usage and consumption that doesn’t want to pay for unused overages, a ‘pay-as-you-go’ contract meets their goal of improved cost management.

For the buyer who has less understanding of their needs, and who does not implement ongoing processes for monitoring usage, the result could be that they wind up paying premium prices when they thought they were reducing their costs. This at least is a fairer allocation of risk from the viewpoint of the outsourcer.

Carriers selling services, which do not change their costing and pricing methodology, may be challenged to adopt a ‘pay-as-you-go’ model whether they like it or not, predicts says Mary Stanhope, vice president of marketing with Global Capacity, which operates an automated exchange platform for telecoms service providers: “Many may be tempted to frontload the pricing,” she says. “This is seen today with fibre network providers who have high price per meg charges for services below 1Gb and 100Mb.”

Balancing capex and opex

The entire mechanics of putting together an effective outsourcing deal, particularly given the current global economic climate, have altered. The key to a deal that works for both seller and acquirer is information. Each buyer will have a unique set of criteria and needs on how an outsourced solution will benefit their business.

This means the provider of services may be making a mistake if they think a ‘cookie cutter’ approach will deliver economies. Outsourcing a service, whether it is operational or based on business solutions, is a unique process between the buyer and outsourcer.

While elements of a deal can be commoditised, the end deliverable usually cannot. And the more complex and geographically diverse the solution, the more the need arises for good communication and clear documentation of deliverables and expectations.

Nothing is more complex that the balance to be struck between capital and operational expenditure, and the calculating of where risk should fall between seller and buyer of services. Jonathan Wright, VP, service provider with European network operator Interoute says much depends here on what the outsourcing customer is seeking to achieve, and for what budget.

“Most outsourcing we provide has an operational and capital expenditure element,” he explains. “The customer might come to us because their equipment is old and there’s a capex side to it from day one, plus an opex one too. It’s important to ask up front what the customer wants from their side.”

Are they looking for their capital expenditure to be amortised over time, or is it important that they always have some sort of ownership, he questions:

“It’s a problem for us when the customer sees us as someone who can bankroll their activities – ‘our network is dead and we need an investment of £10 million to keep going’.”

Ultimately, he says, Interoute’s outsourcing offer can never be purely about solving other people’s capital issues, but needs to be oriented around what professional services they put on top: “We can help with some capex element through that professional services bit,” he says. “The days of 100% cash up front are gone, but whatever our competitors are prepared for we have to follow.”

Will cash remain “king”?

The financing bias displayed by outsourcing service providers has arguably not changed all that much with the years. The preference was always and remains to reduce risky capex in favour of predictable opex.

Rob Smith, director of market development with MDS, a provider of customer management solutions for service providers, says avoiding over commitment of capital is still the rule: “Cash is very much still king,” he believes. “This trend will persist as service providers need ever greater flexibility and cost-efficiency in the delivery of next-generation telecoms and cloud computing services as they strive to grow in a hyper-competitive market.”

‘Pay-as-you-go’, says Smith, at least offers a relatively balanced commercial model that, carefully weighted, will share risk and reward in equal measure between provider and payer – mutually beneficial for both parties.

But money isn’t everything in the context of complex, multi-year outsourcing contracts that include a significant number of variables, such as SLAs and penalties. Effectiveness must be taken into account too. An effective deal, in any global economic climate, must be measured by the levels of value, risk and control allowed by the commercial framework. The mechanics of putting together an effective deal is therefore about understanding the customer requirements such that value is transparent, risk is shared and control is distributed.

“There’s ‘take my assets and rationalise them for me to give an improved TCO’,” says Alam Gill, SVP for international managed services at CSG International. “There are others who prefer a more transaction-based model, which is more collaborative where risk is shared and challenges and opportunities tackled together. You might call this an outcome-based model. The asset model requires very good data to work. We have contracts around all these options. Which is dominant I can’t say. It depends on what the situation is. Tier 1 carriers will differ a lot in their needs to Tier 2s, for example.”

There may be stresses and strains involved with the transition to a ‘pay-as-you-go’ world of short contracts. But just as the old days, it will be the big international outsourcing telcos that who own their own data centres and network that will finish first. They are the ones that can afford to get their return over time. The strugglers will be the newer kids on the block.