May the source be with you

As atbreastudes towards outsourcing become more refined, lawyers need to ensure they are up to speed. Michael Chissick and Belinda Doshi report

It is not often that outsourcing hits the BBC's 10pm news. But that is exactly what happened in June when Powergen announced that it would be closing its Indian call centres and moving its customer services back to the UK.

Nick Horler, managing director of Powergen, said: "Offshore call centres may have their place for certain industries. However, we believe that we can best achieve industry-leading customer service by operating solely in the UK."

He further stated that, while offshore costs can be lower than in the UK, "we're simply not prepared to achieve savings at the risk or expense of customer satisfaction".

Is this the start of a backlash against offshoring, or even outsourcing in general? The reality is far more complex. For those in the outsourcing industry, the move by Powergen is not a new development, but part of a wider trend that has been quietly taking place over the past few years towards a more sophisticated approach to outsourcing.

Reviewing outsourcing strategy The move by Powergen follows that of several other large outsourcing customers that embraced the first wave of outsourcing in the 1990s, only to review their strategic sourcing requirements post-2000. In 2004, for example, JPMorgan Chase cancelled a $5bn (£2.68 plus 1bn) outsourcing contract with IBM. Although JPMorgan Chase chose to bring its services in-house, many other customers choose more sophisticated outsourcing.

One notable trend is for customers to select a panel of service providers rather than a single supplier. Research company Gartner has found that most customers now operate a panel of approximately four outsourcing service providers. What is clear is a growing trend away from the one-supplier model. This makes commercial sense. As the range of services being outsourced has grown, and customer focus has moved away from mere cost-cutting towards accessing innovation, why should one service provider hold all the answers? Customers can also gain a compebreastive advantage by sourcing from several service providers rather than a single supplier. This does, however, require greater management of contract interfaces.

Outsourcing customers are also learning the lessons from the first wave of deals in the 1990s when cost-cutting was the primary focus: this often led not only to back-office, but customer-facing, services being outsourced, and often at the lowest cost. Powergen is one of several companies that has re-evaluated its strategy and is looking to a more intelligent buttessment of which services should be sourced and to which organisation. That buttessment usually includes a more 'output-based' approach focusing on business requirements rather than technical service levels.

Does this mean that customers are moving away from offshoring? Far from it, as the latest reports from the Indian IT trade buttociation, the National buttociation of Software and Services Companies (Nbuttcom), show. The value of the offshore outsourcing market in India, the largest offshoring economy, has grown by an impressive 31 per cent year-on-year, to be worth a total of $30bn (£16.15bn) in 2006. However, what it does show is that customers are adopting a portfolio approach, analysing carefully which services are more appropriate for offshore and which are more appropriate for onshore or even in-house. Part of this development has been the rise of the 'near-shore' option, whereby European customers have outsourced to service providers in other European countries with cheaper wage costs, such as the Czech Republic. With all of these developments, the roles of the customer in-house legal and procurement teams (and their advisers) have become ever more critical.

Taking action While some companies have chosen to rebuttess their requirements towards the end of their outsourcing contracts, an increasing number of companies are not waiting that long. Gartner, in a 2005 report, found that 55 per cent of the companies it surveyed had renegotiated their outsourcing contracts, and many more were considering doing so. Many outsourcing advisers now recommend building into the outsourcing contract a mid-term whole contract review, in addition to smaller regular reviews throughout the contract term.

While each company has its own reasons for renegotiating, certain key trends have become apparent. Most notably, half of all surveyed companies highlighted a lack of flexibility as the key issue for their outsourcing contract. This is a particular risk for outsourcing contracts where contract terms typically range between five and 10 years. Company's requirements will change significantly over that time and the challenge for outsourcing advisers is to try to ensure that the contracts are flexible enough to adapt to new technical and business challenges.

One key aspect of flexibility is access to innovation, both in terms of technology and services. This has proved particularly important as the focus in outsourcings, particularly second generation outsourcings where cost savings have been to a greater or lesser extent achieved, has moved increasingly from cost savings to accessing innovation. How can this be better addressed? It is a question of building in innovation and flexibility throughout the contract and, most importantly, incentivising that activity via the pricing and performance incentive mechanisms. This also comes down to the nature of the relationship that the company wishes to build with its service provider. A hard commercial relationship, which leaves the service provider with narrow margins and little incentive to adapt, will necessarily result in an inflexible contract.

Partnership model Another emerging trend is the move towards a managed partnership model for outsourcings. Early outsourcings were characterised by their traditional supplier-customer relationship, with little attention given to incentivising a mutually beneficial relationship. The high water mark for this approach was reached with the NHS's National Programme for IT (NPfIT).

Although there are many complex reasons for NPfIT's current difficulties, one key point to note is the heavily customer-biased nature of the contract. In brief, a significant part of the risks relating to the programme were transferred to the service providers. It has been reported in the press that the key suppliers have had to write off millions of pounds and that the share price of one of the key subcontractors, iSoft, has more than halved since it issued a profit warning in January this year. Another supplier, Computer Sciences Corporation, has announced significant job losses and has put itself up for sale. The same approach was taken in the Decision Map guidance and model contracts issued by the Office of Government Commerce (OGC).

Meanwhile, in the private sector, more customers are realising that the best environment for an outsourcing relationship to flourish is one where both parties mutually benefit from the relationship. This approach, effecting a managed partnership model, recognises that the customer and the service provider are partners in an ongoing relationship. Interestingly, the OGC is now considering reviewing the Decision Map guidance and contracts. The smart money is on a move away from the NPfIT mode of contracting towards a more partner-like approach being recommended.

Lessons learnt from earlier experiences mean that customers are now more focused than ever on building flexible, innovative, long-term relationships, which are inevitably more sophisticated than those in the first wave of outsourcings - and are based on a more intelligent buttessment of customers' strategic requirements. The challenge for lawyers is to ensure that the outsourcing contract documentation reflects these more sophisticated requirements. - Michael Chissick is head of technology and Belinda Doshi is a solicitor at Field Fisher Waterhouse