In 2019 the global market for IT services will exceed one trillion dollars. Roughly 1/3 of that business will be contracts that come up for renewal and one third of that business will be retendered. One thing that is certain is that contract renewal is big business. It is also clear that the incumbent vendor will have significant negotiating leverage. If the proper counter measures are not applied, customer negotiating teams will be transferring a significant portion of shareholder value over to their providers.
Are your outsourcing contract terms on the horizon? If so, you generally have four options:
- Renegotiate the contract with the existing vendor
- Renegotiate a portion of the contract with the existing vendor and retender a portion
- Retender the entire contract
- Insource portions of the contract
There are a number of factors to consider in making the determination of which path to choose. These factors include:
- Strategic considerations such as a change in technology landscape or vendor rationalization
- Incumbent performance or nature of the current vendor relationship
- Improving the customer’s economic performance by exploring lower cost options
An additional factor that contributes to any contract renewal is the consideration of switching costs. Switching costs can be classified into two broad categories; those costs which are reasonably quantifiable, and those that are more subjective in nature.
Quantifiable switching costs include contractual penalties or lost credits, transaction costs to select and negotiate with a new vendor, transition costs to plan and execute the switch, and the accounting for the redundant service relationships managed during the time of transition.
Subjective switching costs include the consideration of potential business disruption, accounting for lower than anticipated future vendor performance, and the loss of both business and personal relationships that have been nurtured as a result of the incumbent’s engagement.
The risks of switching vendors should not be underestimated. Switching risks are often times greater than the initial transition to outsource. New risks related to the ability to transfer assets between vendors, dealing with the incumbents fixed contract time horizon, and the ability to transfer knowledge from one vendor to another are typically not easily mitigated.
Here are a few things we can learn:
- If the incumbent is perceived as delivering high value, then there is likely to be a corresponding perception that switching costs are high
- If the perception of switching costs is high, the likelihood that the sourcing organization will choose to retender vs renegotiate is diminished
- There is some qualitative evidence that suggests that if the incumbent and the client have customized the service offering to fit the client’s needs, clients may feel guilty evaluating alternative suppliers
Well managed vendors recognize the importance of switching costs. These vendors understand that switching costs create a barrier of entry for competition. These costs therefore become a factor in driving price during contract renegotiations. The vendor playbook to build the client’s perceived switching costs typically includes: offering rewards based upon volume or duration with the brand, building a client’s dependence on vendor’s proprietary assets to deliver the service, and bonding with the client in some intangible ways that fulfills personal needs and desires. Once the psychological platform of high switching costs has been laid down, incumbents can drive pricing higher during renegotiations knowing the client is less likely to consider switching.
Customers can regain some of this psychological leverage by running their own playbook to lower the incumbent’s perception of switching costs. This playbook should include three sections:
1. Initial contract negotiations
Include actions to lower switching costs such as clearly defining exit terms and responsibilities, licenses to utilize assets in perpetuity and methods of dealing with end of contract credits.
2. Vendor management
Identified countermeasures that can be implemented which reduce the vendor’s ability to increase perceived switching costs without diminishing the vendor’s value proposition. Tactics include documentation audits, client tracking of vendor performance, and C-level briefings on incumbent performance.
3. Renegotiation strategy
A well-defined plan for negotiating contract renewal that works to reduce the vendor’s perception of switching costs. Steps in this strategy include an early start supporting the concept that switching is actually an option, providing honest feedback regarding vendor performance, and demonstrating knowledge of current price and service levels available in the marketplace.
With the average size of renegotiated contracts ranging from 20 to 40 million dollars and renegotiation frequency increasing, customer negotiating teams can no longer hand the perceived switching cost advantage over to the vendors.