During the past year, 50% of 1,073 organizations worldwide saw a sharp uptick in outsourcing contract renegotiations, according to recent research from Gartner Inc. in Stamford, Conn. Many of those contracts were renegotiated in a bid to cut costs, due to the recession.

The recession causes bad behavior on both sides of the coin, the client and the supplier,” said analyst Allie Young, research vice president and distinguished analyst in Gartner’s technology and service provider group.

This seemed like a good time to look for the warning signs of an outsourcing deal gone bad. We spoke with three experts on the misconceptions, missteps and mistakes that spell trouble. In this first article of a two-part series, TPI’s Thomas Young, explains how lack of innovation and productivity gains, as well as culture clashes, can break down an outsourcing contract. Be prepared for self-examination. Many of the telltale signs have more to do with your organization than the provider.

Thomas Young is a partner and managing director with the CIO Services-Infrastructure at TPI, an IT consulting firm based in The Woodlands, Texas. Prior to joining TPI, Young was financial director at AT&T Labs, another TPI client. “When it comes to outsourcing deals, I’ve seen every bad movie you can imagine,” he said.

Innovation vs. continuous improvement in outsourcing contracts

Young said one of the biggest complaints he hears from CIOs is they aren’t getting innovation out of their deals. “My question is, ‘What did you think you were going to get?’ There is no provision in the contract for innovation,” he said. The CIO will mumble something about the sales meeting where promises were made, Young said.

The key to a successful outsourcing contract is documentation, he explained.

Innovation is difficult to document in an outsourcing agreement, and real innovation in any case is quite rare in mature industries. “That is why everyone is mesmerized by Apple,” Young said. CIOs tend to think that because they’re doing $100 million worth of business with a major outsourcing provider, they are going to get special access to some cool new technology. But that is not the case.

“About the best we have been able to do is dedicate a pool of resources from the supplier side, whose job is to sit in the client’s business and look for new opportunities to bring new projects to bear,” Young said. But that solution may be no better and worse than seeding one’s own research and development.

“Is the IBM guy better than what you could buy in the open market? That’s mixed,” he said, adding that in his view, innovation is better bred into the company culture.

Continuous improvement is another matter. Normal (and nominal) productivity gains are about 3%, maybe 4% in IT, Young said. Productivity gains greater than that usually require investment on both the client and provider side, and both kinds should be explicitly articulated in the contract. Providers that can bring 5% to 10% productivity gains are investing in the tools, automation and methods that bring continuous improvement. An application development outsourcing project with code that’s undocumented, buggy and expensive to maintain, for example, will require the client to invest in retooling the software to achieve meaningful productivity gains. “Over time, the defects go from 1,000 per million to low single digits, because the software is retooled, and we put that into the contract,” he said.

Company culture and outsourcing contracts

Beware the productivity gains that will not happen at any cost because of company culture. Young gave the recent example of a very large outsourcing firm brought in to consolidate the IT environment as part of a business transformation project. The environment in play: 3,500 servers, running at a 15% utilization rate. “The provider comes in and says we can virtualize the environment, stack it up and get them down to 20:1 on big boxes. We said, ‘[There's] no way are you are going to do it,’” he said. The provider guaranteed the work.

Technically, the supplier could absolutely do it, but Young said he knew the political environment jeopardized, if not precluded, success. The CIO did not have control of his app dev teams and could not get them to consent to any changes for recompiling or adjusting the code, or freezing the code so it could be tested. “It was a dynamic environment where they were constantly making changes to applications, so they would not agree, right or wrong,” he said. Plus, the CIO did not have application performance metrics, so any change in response time was attributed to the virtualization efforts, and there was no documentation to prove otherwise.

The job was not done. The supplier did not, as promised “eat the costs,” choosing instead to be the “bad partner.” The contract was readjusted, but the experience was “not good,” he said.

Optimizing price but ignoring quantity in outsourcing contracts

CIOs focused on cutting costs do a good job of optimizing price by using outsourcing, but they tend to ignore consumption of services by users. They need to do both.

When Young was at AT&T in the late 1990s, chairman Mike Armstrong wanted to reduce the $3.2 billion IT spend by half, in two years. The CFO’s answer was more outsourcing. “That will get you 15% to 20% and you are done, because you are locked into a contract and can’t go much further,” he said. Outsourcing providers are not incentivized to reduce costs when you sign a contract. Young’s team launched a parallel effort to reduce consumption by introducing a rigorous chargeback methodology so people could see the cost of what they were asking for — and pay the bill.

“We never made it to 50%, but we reduced costs a lot,” he said. “When I tell clients to take costs out, I tell them to focus on the Qs.”

Governance and outsourcing contracts

The cost of writing out the terms of an outsourcing contract can come out to about 1% to 2% of the total contract value, counting attorney fees. The bigger the deal, the lower the cost — but not low enough to renegotiate annually. Good contracts are written to be as flexible as possible, to accommodate changes in the business and technology and the provider’s business. The trend for a while has been toward five-year deals, but many companies don’t make it that long, and cloud computing could lead to even shorter agreements.

Young said a big mistake people make is that after doing a yeoman’s job on the initial contract, they neglect governance and contract “maintenance” that will keep the contract fresh. Even CIOs with $200 million of external spend on 20 outsourcing contracts will put their “C” students on invoice verification. A $12 million per year contract that the CIO agonized over will creep to $18 million because managing the invoice and the contract was the employees’ “night job,” an afterthought, Young said. “Vendors love the afterthought mode,” he said.