The credit crunch is undermining the economic model of outsourcing, with discounts offered in the early years of a contract disappearing in the face of the recession.
An analysis by Compass Management Consulting of more than 125 outsourcing deals found that discounts usually offered in the early years of an outsourcing deal are no longer available, and the financial crisis is having a dramatic effect on the pricing of long term outsourcing deals.
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In recent years, outsourcing providers have made long-term deals attractive by offering "significant discounts" for the first year of the contract. This initial discount is recovered in the later years of a contract, when charges can be 30 percent or more above a comparable internal market rate, Compass said.
Outsourcers are "unwilling or unable to fund losses" by offering discounts to enterprises during the early years of contracts, the consultants group said.
"Outsourcing is no longer a source of working capital for corporates nor a vehicle for financial engineering. Fewer outsourcing providers are entering into contracts that have negative cashflow in year one in order to fund a short term discount for their clients," said Andy Gallagher, consulting director at Compass.
"Just as the credit boom transformed the outsourcing sector's ability to fund discounts based on an annuity stream from contracts, the shrinkage of credit will have a transformational effect on the sector. The economics of outsourcing and the way deals are managed is going to change radically in the months to come," he said.
According to Compass, most sourcing deals before 2008 were fixed-price for the duration of the contract period or set at a baseline price which increased at a pre-determined figure each year. The multiplier for the increase was normally linked to the retail price index (RPI) or the consumer price index (CPI) for the year in question. This pricing approach was designed to be below market price in the early years of the contract and above in the later years.
In 2007, 90 percent of contracts followed this "flat line" pricing model, where discounts needed funding in the early years. But by the second half of 2008, this figure had fallen to below 65 percent as vendors moved to a pricing approach that tracked their own forecasts of changes in the market over the contract period or compared the contract price with actual market rates.
With these upfront savings now removed from many deals, Compass predicts that customers will have to work more closely with providers to gain value and achieve sustainable cost reduction throughout the duration of their contracts.
"We are already seeing the best performing companies working to understand their existing operational performance, how they compare with best practice and what opportunities exist for improvements. With that understanding comes a more constructive approach to contract management," said Gallagher.
Compass also warned that many enterprises could be paying for costly customised services from outsourcers for IT services, such as desktop desktop management, when a standardised service would provide savings, Compass suggested. A standardized service offering could generate savings of up to 30 percent and still meet a company's requirements, the consultants said.
Computerworld UK is an InfoWorld affiliate.
This story, "Credit crunch changes economics of outsourcing" was originally published by Computerworld UK.