Sourcing Inside Out: Why Vendors Don’t Like Benchmarking Clauses

Benchmarking clauses are written into most outsourcing contracts to mandate a periodic review of rates and quality against industry standards. The purpose of a benchmark clause is to validate that you’re paying a fair price and getting reasonable service. This kind of ongoing analysis is critical given today’s rapidly changing business environment and the complexities of most outsourcing agreements.

Sounds reasonable. So why is it that many service providers do their best to avoid benchmarking clauses?

The biggest problem service providers have with benchmarking is that it reveals that, for large well-run organizations, outsourcing is almost always more expensive than keeping services in-house. While up-and-coming tier 2 and tier 3 vendors have recently offered aggressive pricing, Compass benchmarks have shown that the pricing on large, long-term outsourcing contracts can be 30 percent to 40 percent greater than a group of best performing in-house operations of similar size and complexity.

Looking more closely, we need to emphasize the qualifier of “best performing in-house operations,” because becoming a best performer requires a great deal of time, effort, and investment. In other words, for many companies, outsourcing will be cheaper.

We also need to consider pricing over the life of the contract. Many client companies mistakenly focus on short-term cost savings during negotiations — and ultimately pay for it down the road. We’ve seen savings of 18 percent (10 percent to 15 percent is more typical) in year one of a contract turn into unit costs in excess of 23 percent above market rate by year two. By the end of the term, the gap to market rate can be in excess of 50 percent.

This commonly employed negotiation strategy — known as “back-end loading” — accounts for a large portion of service provider opposition to benchmarks. Under this approach, the vendor accepts a break-even or loss at the beginning of a contract (usually the first 18 months), with the expectation of recovering those losses during the latter stages of the deal. Looked at this way, it’s a bit unfair for clients to complain about high prices at this point, since they got a break early on, and since, moreover, they negotiated the terms and should be accountable.

In any event, a benchmark understandably conducted towards the latter part of the contract term spells trouble for the vendor, since it can adversely affect the “sweet spot” of the deal for the vendor. A snapshot view of rates late in the contract term can make it look as though the vendor is making a killing, when a long-term perspective will show that the vendor is simply recouping the losses made in the early years of the contract.

Another problem vendors have with benchmarks is that they generally represent a lose/lose proposition. The results are generally non-negotiable, and vendors have no recourse to challenge or rebut the findings. Perhaps worse from the vendor’s perspective, the benchmark results generally only work one-way: If a client pays too much for services, then the vendor must provide compensation. But if a benchmark reveals that a client is paying below market rates, rates don’t increase to align with the market.

Finally, benchmark clauses often set performance targets unrealistically and unfairly high. Rather than defining price and performance standards that are the average of world-class organizations (which is reasonable), many benchmark clauses stipulate that the vendor must match the top 10 percent of industry performers within each category. That’s like asking a track athlete to compete in the 100-meter dash as well as the marathon.

So What Do You Do?

How can the two sides work together to ensure that the benchmark is a reasonable process that keeps a relationship on track, rather than a nickel-and-diming bone of contention? The best way is to take a big-picture view of the process. Specifically, approach the discussion with the attitude that you brought to the early days of the relationship, when you were setting out to forge a value-based strategic alliance. Use the benchmarking discussion to re-introduce these strategic elements into the relationship, and not as way to beat 10 percent off the price.

Towards that end, it’s essential to ensure that the reference comparisons used in the benchmark are accurate and meaningful, and provide an apples-to-apples view of your performance against what’s happening in the marketplace. In many cases, you’ll need the help of an objective third party that has access to a variety of operational data, a methodology to normalize and adjust the numbers, and the ability to make the process transparent to both sides.

From the vendor’s perspective, it’s essential that you as the client acknowledge and support the service provider’s desire to earn a profit. You should be willing to pay for services based on fair market value, rather than on a vendor’s cost of delivery. For example, if $10 per call constitutes a fair market price for help desk services, then you should agree to pay that rate — even if you know that your vendor is able to deliver that service for $5 per call. By succeeding, your service provider will be motivated to support benchmarking initiatives and to continue to invest in innovation that results in better service for you.

In other words, a win/win.

Useful Links

Compass
http://www.compassmc.com/services/destinations/sourcing.htm