July 2004, EDS made a startling announcement when declaring its quarterly results. Tucked away in the midst of its earnings report was a line that announced, it has reached an “amicable agreement” to pay $ 135 million to get out of a bad commercial contract. Though the company declined to identify the customer, market speculation was rife that it was Dow Chemical.

Apparently EDS CEO, Michael Jordan drew up a hit list of troublesome contracts to see whether they could be salvaged. While most of the other contracts were turned around, this was the only contract that could not be retrieved.

What could go so wrong to make a vendor decide to pay its way out of a contract?

While it is not common for a vendor to walk out of contracts, contract termination by customers has become commonplace. In September 2004, JP Morgan announced that it had terminated its IT outsourcing contract with IBM after its merger with BankOne. The seven year $ 5 billion deal, signed in December 2002, was billed as IBM’s poster child for its on-demand business. More recently in May 2005, Sears terminated its 10 year $1.6 billion IT infrastructure support services with CSC citing, “...failure to perform certain of its obligations”.

These were the most high-profile deal failures. A quick Google search is bound to throw up a dozen deals that went belly-up.

And if that were not enough, analysts had also been predicting with alarming regularity the pitfalls in IT outsourcing contracts. Gartner warned 80 per cent of customer service outsourcing deals will fail because they are too cost-focused and renegotiation will become common. Deloitte found 70 per cent of its survey participants were disappointed with outsourcing and were considering in-sourcing. (Deloitte took its findings seriously and exited the BPO business by selling its F&A BPO to Convergys recently). The Datamonitor quarterly IT deal tracker has found that deal sizes have consistently been on the decline.

So what exactly is going on? What happened to the great dream called outsourcing? Is the halo around the much-hyped concept of outsourcing beginning to fade? Are customers so disillusioned, as to walk out off contracts that were once hailed when they were signed?

The truth is just the opposite. Outsourcing is alive and kicking, but as a mature phenomenon. News about termination of contracts or renegotiations are reflections of a vibrancy in the sector that was not seen in the early days. The initial experiments have convinced customers about the benefits of outsourcing. With their studied approach, outsourcing has become a strategic tool rather than a tactical move. This is a significant shift in the customers’ learning curve, spurring organizations to revamp earlier associations.

Even to the casual eye, mergers and acquisitions will appear as one of the most frequent reasons why deals are getting axed or brought in-house. Both the JP Morgan and the Sears deal got scrapped after their merger with BankOne and KMart respectively. While JP Morgan wanted to leverage on the more efficient IT systems within BankOne, it was the internal politics at KMart that resulted in the termination of Sears’ outsourcing contract to CSC.

Mergers and acquisitions aside, the changing dynamics within the industry has made organizations bold enough to scrap untenable deals or consider deal renegotiation. No longer a contract spread over 7-10 years deemed so sacrosanct that it cannot be touched before the expiry of its term.

To understand today’s scenario, let’s rewind to the early phase of outsourcing. A lot of IT Outsourcing (ITO) contracts were signed during the economic downturn in 1999-2000. Companies were under pressure to cut costs and outsourcing was an immediate step they could resort, to affect savings. “Much of those decisions were taken as a knee-jerk reaction and were tactical in nature,” says Gianlunca Tramacere, Principal Analyst Research, IT Services and Sourcing Group, Gartner. And, a lot of cracks are now showing in those ITO deals because they were not aligned to the needs of the organization.

Added to the flaw of hurried decision-making was an even bigger baggage of inexperience. Organizations had chosen to outsource as response to immediate market condition and specific opportunities to cut costs rather than any long-term strategic thinking. Which is why we find an increasing number of organizations taking a re-look at their earlier contracts.

ITO is a hugely complex phenomenon and unfortunately organizations have begun to realize it only after burning their fingers. Customers need to have management bandwidth to manage the migration and ensure smooth operation. Outsourcing is not a one-time affair that can be forgotten after it is handed over to the supplier but requires continuous close co-ordination with the supplier.

Says John Powers, Senior VP, Solutions Management of ACS, “The dynamic nature of business entities can challenge any structured solution and services contract. And the health of the servicing agreement is based on the relationships and cultures of organizations with an acknowledgement of managing expectations.”

In fact many deals involve integration or migration of complex collections of legacy systems, often involving disparate platforms and highly patched in-house applications mixed with off-the-shelf applications and custom applications. “When firms take on the outsourcing of legacy systems like these, it is almost inevitable that there will be delays and missed milestones, at least during the initial phases of the migration. If the customer is impatient and becomes discontent with initial progress, as is often the case, the ITO deal may be scrutinized and scrapped,” says Michael Guilbault, Analyst with Technology Business Research Inc.

Customer impatience is often because of inflexibility in the deal. Sometimes deals are so inflexible that customers are forced to sign a fresh deal each time there is a requirement. For instance, Continental Group-the leading tire, auto component and electronics maker-signed as many as 30,000 deals with IBM between 1995-2001 during its ITO contract. With each contract, costs spiraled making the project completely unviable and ultimately the deal had to be scrapped.

		Each time a customer asks for a new service, there is an additional cost for vendors
GIRISH S. PARANJPE, President Financial Solutions, Wipro

Vendors on the other hand allege that outsourcing deals are inflexible because customers are too focused on driving down costs, often at the expense of other expected benefits. Customers cannot ask for innovation without being ready to pay for it. “Each time a customer asks for a new service, there is an additional cost for vendors because he has to invest and the customer has to understand that. Otherwise the deal becomes unprofitable for the vendor and the vendor can even opt out of such contracts,” says Girish S Paranjpe, President Financial Solutions, Wipro Technologies. The EDS-Dow Chemicals contract is a case in point.

In fact being too cost-focused can sometimes backfire on the customer. A LogicaCMG report-The CEO role in delivering strategic advantage-says that while driving down costs, it can also cost profitability and market share and illustrates it with an example of the Xerox-EDS deal. The deal signed between 1999-2004 brought down costs for Xerox but the company lost control over its billing and sales commission system which badly hit its profitability. Talk about being penny-wise and be pound-foolish! Who do you think can be blamed in this case? Sometimes it pays to have a long-term perspective than revel in short term cost savings. Of course there may be individual imperatives and it is for each organization to take a call.

That is why some suppliers have rightly taken the stand that unless customers understand their needs and design outsourcing contracts accordingly it will do no one any good. Says Powers, of ACS, “Customers must acknowledge problem operations cannot be sold off in a service contract. Outsourcing does not advocate your mess for less.”

With hindsight another realization has dawned on the industry: that outsourcing is not simply a technical decision as much as a business equation. ITO cannot remain as a compartmentalized project executed without a business vision. Paul Schwefer, Vice President and CIO of the euro 12.6 billion Continental Group puts it succinctly, “You have to bring a business perspective to technology.”

		Customers must acknowledge that problem operations cannot be sold off in a service contract
JOHN A. POWERS Sr VP, Solutions Management of ACS

An increasing number of people are subscribing to that view. Peter Bendor-Samuel, who has worked as a buyer, a supplier as is now a consultant writes in his book, Turning Lead into Gold, “The first thing a buyer and a supplier must do is put a businessperson in charge of the outsourcing process.... a businessman can understand the overall context in which the relationship takes place and is able to take a balanced approach to issues.”

Schwefer is the new breed of CIO who does not have a technical background. His achievements include successful stints at Mercedes during the 1980s where he hived off the company’s IT operations to T-Systems. He describes himself as a ‘business person’ who joined the Continental Group in 2001 to take over the ongoing ITO program of the group, which was in disarray. Schwefer took a fresh perspective to the initiative and saw the problem for what it was: he found costs were too high, quality levels not up to the mark, and technology was not up-to-date.

Schwefer scrapped the deal, entered into a fresh relationship with IBM Global Services and brought back a lot of functions in-house to regain control of the program. He is subsequently talking with HP to enter into an innovative relationship where the cost is measured on the basis of a pre-agreed “index” that takes into account all variable factors such as cost of the computing hardware and what’s more, pay only if he uses.

Schwefer is a bit of a maverick, though. He believes that his IT requirement can be divided into two parts-the big chunk that includes hardware and infrastructure along with standard applications accounting for 80-85 per cent of his IT requirement; and the rest 15-20 per cent which is a small but crucial part of his business applications. He calls these niche business-requirement to which he pays detailed attention. While the bulk is outsourced to a service provider, the SLAs for which he thinks can be measured through metrics, he wants a more controlled environment for the specialized needs by working partly in-house and partly with a small third-party who under stands his business and culture and can innovate accordingly.