Companies are on the horns of a dilemma. They signed long-term, managed service contracts for IT or business processes, which took advantage of the savings from labor arbitrage. But now they find that there is significant potential to leverage the new suite of digital technologies that promise improved performance and lower cost. The problem is that that their incumbent service providers often actively resist implementing these technologies, using delaying and obviation tactics, refusing to pass on the savings and/or demanding additional work or other concessions in return for complying. Now that I’ve identified this major issue that many companies face today, let’s look at how they handle this non-alignment situation.
Three things happen when your company introduces digital technology and automation into an existing service agreement. First, the service provider’s current model is largely based on labor arbitrage. The number of people for which to charge your company will diminish as the provider substitutes technology for labor, thus reducing the provider’s overall revenue.
Second, companies usually automate functions that have high standard operating procedures (SOPs), which are largely the rote, simple work. That work is disproportionately offshore today, and it’s also the highest-margin work for service providers. Therefore, in addition to reducing the provider’s revenue, introducing digital technology into a company also reduces the provider’s margin.
The third component of what happens is tied to ownership of the technology. There is no reason for the service provider to own it. Companies are implementing bespoke digital platforms, often owned by the enterprise customer. Thus, the provider loses control of the technology.
These three factors affect the short- and long-term interests of a service provider, causing misalignment of interests for the remainder of the multi-year services contract.
In such a situation, should your company wait for the contract to expire or delay the building and implementation of a digital platform? No, that makes no sense, given the cost savings alone. Digital platforms often yield 30-60% reduction in total cost of operation (TCO) and significant business value such as time to market and market access. Yet, how can your company work with a service provider whose interests are not aligned with yours?
What can a customer do about the misalignment?
Companies are using a variety of tactics to deal with this evolving situation. But all options or techniques come with a significant cost or effort as well as significant risks. So, dealing with the misalignment problem necessitates taking a tortured path.
Here are six different techniques and options that companies are using to achieve their goal. Some are using multiple options.
- Go ahead and build a digital platform while your service provider is still in place. The average time to build a digital platform is three years (or even up to five years), and most managed-services contract are for five years. If your company asks its current service provider to build the digital platform, your company can still transition that platform when the contract expires.
- Service contracts are often based on an FTE basis. So, your company’s costs will go down as you implement a digital platform simply because you’ll pay for fewer people to operate it. Notwithstanding, you still will have the issue of how to drive cooperation with the incumbent service provider. One motivating mechanism is to pay your provider to build the digital platform. But that strategy has complications in that the provider will build that platform so that it ties into its business. The provider also could build aspects of the digital platform that you might otherwise build yourself. So, this strategy carries dueling motivations.
- Another technique is to use a different partner to build the digital platform instead of your existing service provider. Using this strategy, you will need to manage the communication between the two service providers. This introduces the risk of disfunction into your company’s relationship with its incumbent service provider going forward.
- Some companies use the technique of benchmarking to deal with the misalignment issue. They add a digital benchmarking clause to the contract to try to create a contractual forcing mechanism for the service provider to lower costs.
- Another option is to drive a portfolio rationalization across your company’s service providers, basically taking work away from some and giving more to others. The hope in this strategy is that the consolidating service provider will be motivated to build the digital platform in alignment with your company’s interests.
- Finally, your company has the age-old remedy of terminating the contract early. If you find the service provider is unwilling to change now, to realign interests for implementing digital technologies, you can pay the early-termination fee and seek a provider that will align with your interests.
Digital technologies present extensive opportunities for companies to rethink their business to create better customer experiences, create new value and lower costs. Building and implementing a digital platform is at the core of digital transformation. But most companies today cannot build a platform alone and must rely on third-party services. Therefore, companies need to better understand what is involved in building a digital platform and the risks in using service providers that are not aligned with their customers’ interests.
From a customer perspective, a multi-year managed services contract includes the significant benefit of having a service provider that understands the business and is available to respond to needs without having to go through a large learning curve. But the digital world changes that fundamental assumption in those contracts because it introduces the misalignment of interests that I discussed in this blog.
I don’t believe managed-services contracts will go away. But companies need to find a service provider that is the right fit and will make the necessary changes to align the provider’s interests with their customers’ digital interests.