What Does It Take to Get IT Outsourcers to Innovate?

John Smith had high hopes when Science Applications International Corp. (SAIC) took over Entergy’s IT. Before the New Orleans–based utility signed the five-year, $400 million contract in 2000, SAIC’s sales team described a rosy future in which it would lower Entergy’s IT costs and improve service levels on everything from application development and maintenance to data center management to desktop and infrastructure support. And more than that, SAIC said it could become Entergy’s partner in IT innovation.

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“A partner in innovation”—those were magic words for Smith, then IT director for Entergy’s Southern Nuclear fleet.

“We were looking for a company that would do more than just manage our IT service delivery,” says Smith. “One that would not just provide best practices and run IT like a railroad but could also provide some vision about where IT was going.” Smith, currently in a temporary role assisting in the reorganization of Entergy Nuclear, was particularly interested in SAIC’s nuclear domain experience and its ability to apply that knowledge to the introduction of new business-specific systems.

But as the relationship with SAIC matured, Smith’s disappointment grew. “Innovation was an expectation that wasn’t delivered on,” he says. SAIC met its service-level agreements (SLAs) and kept Entergy’s IT costs under control, but there were no new ideas coming from the outsourcer, no guidance about emerging technologies Entergy should pursue. In short, no partnership in innovation.

The Innovation Promise vs. the Innovation Reality

When it comes to why SAIC failed to meet Smith’s expectations, there’s plenty of blame to go around. Smith suspects SAIC overstated its ability to move beyond the traditional provider’s role of managing IT as a utility. He also admits that Entergy’s leadership was unable to figure out how to manage the relationship with SAIC in a way that would encourage that kind of strategic involvement. Perhaps most important, despite what both sides said, innovation was never officially part of the deal.

“When we were all sitting in the room, there was all kinds of talk about what might be possible,” says Smith. “And what was possible got sold a lot harder than what actually went into the contract.” (SAIC declined comment on its relationship with Entergy.)

Smith is not alone in his frustration. Forrester Research reports that 42 percent of buyers are dissatisfied with the innovation provided by their primary outsourcer. According to a recent CIO survey, 44 percent of respondents were unhappy with the innovation provided by offshore outsourcers. (Twenty-one percent were dissatisfied with the level of innovation provided by domestic providers.) Of course, these numbers don’t take into account IT leaders who are entering their deals with limited expectations or who are looking for more straightforward relationships with providers.

“When you talk to suppliers before the contract is signed, they talk innovation,” says Mark Kobayashi-Hillary, offshoring director of the National Outsourcing Association (NOA), a U.K.-based outsourcing trade organization. “Once it’s signed, they need to service the SLA. So you’ll find outsourcers that hit all the key indicators and still the client is not happy.” CIOs “look at the dashboard and see that everything’s green,” says Ben Trowbridge, CEO of outsourcing adviser Alsbridge, “but they still feel red.”

According to an Alsbridge survey of 300 buyers of IT services, the biggest gap between outsourcing benefits sought and achieved exists around innovation. The same research found that suppliers themselves say that their inability to innovate to client requirements is their biggest challenge.

As was the case at Entergy, both sides, customer and provider, bear responsibility for the failure to deliver on the promise of innovation. Though EDS or IBM may sell the idea of transformation, and offshore providers like Tata Consultancy Services (TCS) or Satyam may say they want to deliver higher value services, the former can’t afford to do so due to decreasing profit margins and the latter built their businesses on commoditizing IT services, not innovating. And while IT leaders may say they want something more than “your mess for less,” for the most part they’re still focused on price, according to outsourcing experts. Most IT shops, says Trowbridge, are unable either to manage the relationship with their outsourcers in a way that yields innovation or are ill-prepared to implement the changes they say they want. Even when buyer and seller think they’re on the same page, a clear definition of what constitutes innovation is rarely built into the deal.

That leaves CIOs with two options if they’re looking for innovation: Make radical changes to the way they establish and manage those relationships, or give up on the idea entirely.

The Innovation Debate

There are two schools of thought about whether IT organizations should look to outsourcers for innovation. “If you’re a big retailer and you’ve outsourced IT to IBM or TCS, those are the guys who are going to understand the way technology is changing, whether it’s SOA or green data centers or using Web 2.0 to reach the customer,” says Kobayashi-Hillary. “If you’re a bank or a utility, you’re not going to be an expert on social networks or how to utilize Second Life in the business. The service providers are.” Outsourcers, after all, have strong partnerships with hardware and software vendors. “They’re looking at the technology space, and their expertise and knowledge is far greater than what exists in our IT organization,” says Robert Taylor, VP of IS for the $14 billion design, engineering and construction company Fluor. “The folks there know where IT is heading and we’re looking to them to bring that expertise to us.”

Others disagree. “I’ve had a few IT executives tell me that they were disappointed that their outsourcing vendor hadn’t done much in the way of innovation. It’s an odd expectation, and a tough one to put into the contract,” says Jeanne Ross, principal research scientist at MIT’s Center for Information Systems Research. “Vendors will innovate to the extent it saves them money or helps them introduce new products or services, but that won’t feel like innovation to the customer.” For an outsourcing provider to offer competitive differentiation for a customer would be contrary to what they’re set up to do, says Barry Rosenberg, a partner with outsourcing adviser Pace Harmon. IT service providers make money when they can standardize processes across their customer base. You’re not buying an innovator, says Rosenberg, “you’re buying a factory.”

Outsourcing sales teams, however, haven’t gotten that memo. “The providers will tell you they’re going to transform your business,” says Gartner Research Director Dane S. Anderson.

“A lot of that is hype.”

Overinflated claims from salespeople? Say it ain’t so. But whether CIOs ought to expect innovative, transformational help from an outsourcer may be a moot point. Could they provide that kind of partnership even if they wanted to?

Perhaps not.

Tips to Get Your IT Services Providers to Innovate

Outsourcing providers are more likely to introduce innovative ideas if they’re hungry. That’s why Ed Hansen, partner in law firm Morgan Lewis’s global outsourcing practice, often advises his clients to take IT services that might be ripe for innovation out of the defined scope of services.

For example, if you’re on the verge of signing a $20 million outsourcing contract, $4 million of which is development work you’d like your provider to approach in a new way, make it a $16 million contract. “Give the outsourcer a position in your organization so that they can understand what’s going on in your business and give them the opportunity to earn that $4 million by coming up with innovative project ideas,” says Hansen. “It puts the economics back where it belongs.”

The idea of actually encouraging your provider to continue to sell new ideas to you after you’ve sealed the deal may be a turnoff to some IT leaders, but Gartner’s Dave Anderson says he’s seen positive results. A customer may hold regular brown-bag sessions, during which his vendor pitches new ideas. The client requires that the vendor bring a third party either to back up the sales pitch or weed out ideas that are purely self-serving.

Some ideas have been approved and turned into additional work for the vendor. “You don’t want to turn them into a bunch of used-car salesmen,” says Hansen. “But if you take them out of that guaranteed revenue position and treat them as a trusted adviser, it encourages them to look for new opportunities.”

They key words are “trusted adviser.” To get innovation you have to “trust the vendor enough to let them under the tent, sharing and getting ideas,” says David Rutchik, partner with outsourcing adviser Pace Harmon.

Not only do you have to give the vendor a seat at the table, you need to make sure you’ve got the right person in that seat. Hansen is currently renegotiating a nine-year outsourcing contract for a customer disappointed with the lack of value-added service provided by the vendor. The customer had stipulated that someone from the vendor sit in on CEO-level meetings, but that someone turned out to be the guy who “kept the lights on,” says Hansen. “You don’t want the data center guy in on those meetings. You want the former analyst-types to be part of that.”

Traditional outsourcing pricing models can also discourage innovation. “[CIOs] are starting to look at more innovative pricing models,” says Ben Trowbridge, CEO of outsourcing adviser Alsbridge. One organization Trowbridge advised chose to go with the one vendor who offered a business metric–based pricing model. The customer would pay the outsourcer $1.15 per claim that was paid. Period.

“The provider had to think of all sorts of innovative technology they could use to make sure that they earned as many claims as possible,” says Trowbridge. “The customer got the full benefit of working with a $20 billion outsourcing provider; the provider has a chance to increase its margins by sharing in the growth of the customer’s business.”

The SLA Trap

“Innovation and operating margins go hand in hand,” says Alsbridge’s Trowbridge. And U.S.-based outsourcers are getting squeezed. If you edit out the short-lived reprieve of Y2K and the dotcom days, outsourcing margins in the U.S. have been declining steadily since the mid-1970s and have flatlined at 6 percent, with just 9 percent annual revenue growth, according to Alsbridge. “When the crunch hits,” says Gartner’s Anderson, “outsourcers do the bare minimum to succeed.”

The financial pressure on domestic providers is the result of offshore competition, primarily Indian vendors who are riding high with double-digit profits. But don’t count on them to fill the innovation gap. “They didn’t get where they are by innovating,” says Kobayashi-Hillary, author of Outsourcing to India: The Offshore Advantage. “They got there by repeating the same processes over and over again.” Plus, they have their hands full managing their own growth.

Thus, outsourcers around the globe are loath to do anything that might affect their ability to meet their service-level obligations and thereby reduce their margins. “Providers are delivering to a contract, and it’s difficult to build any kind of innovation into the language of the contract,” says Kobayashi-Hillary. “There’s a difference between what you sat down and talked about with the outsourcer and what’s written in black and white. It’s just not in the supplier’s interest to proactively change anything.”

Indeed, most outsourcing SLAs and pricing models deter innovation. Take data center management. It’s the outsourcer’s responsibility to ensure 99.99 percent uptime or provide backup services. “The value add would be when the service provider looks at the environment and says, Now I understand how you support your business and I see that by leveraging this new technology or different hardware, we can improve the quality of the service or your costs,” says Taylor of Fluor, which is on its fourth major outsourcing contract since the mid-1990s. “But you’re paying the vendor X dollars per server so there’s no motivation for them to reduce that number.”

“There’s so much change management embedded in outsourcing processes to prevent them from missing an SLA, their ability to innovate to support our business is very limited,” agrees Robert Fecteau, CIO of BAE Systems Information Technology, a line of business within the U.K.-based BAE Systems. Fecteau was hired in 2005 to oversee the backsourcing of U.S. IT services previously outsourced by its parent company in a $2.2 billion, six-year IT contract with CSC. (The rest of BAE Systems will continue to work with CSC as “a trusted partner critical to our success,” says Fecteau.) According to Fecteau, BAE’s outsourcing had been driven by a desire to cut costs. (In addition to the design, manufacture and maintenance of military vehicles and equipment, BAE Systems provides IT services.) But there were trade-offs.

“It’s very difficult to write a contract with an outsourcer that says, ‘Give me more innovative IT processes,’” says Fecteau, who will complete the backsourcing process during 2008. “They’re not there to transform your organization,” he continues. “They’re there to deliver IT as a commodity.” Fecteau should know since BAE Systems is itself in the outsourcing business. “The very nature of outsourcing naturally restricts innovation,” he says.

Processes further inhibit the kind of client-vendor interaction that would yield innovative solutions. “I don’t think the big outsourcers do well with customer intimacy,” says Fecteau. “They’re huge, matrixed organizations with revolving doors. You never know who’s coming in on a given day.”

“We would clearly disagree with any assertions that large outsourcers such as CSC can’t bring innovation to outsourcing engagements,” says CSC spokesman Mike Dickerson. “In this case, BAE Systems’ decision to insource certain operations was based on a long-term strategic objective to grow its computer services business in the federal IT services market, an area in which we obviously compete, and is not a reflection of the services provided by CSC.”

If you really want innovation, you can get it, says Fecteau, “but you’ll pay for it.” Dearly.

You Get What You Pay For

That gets at another impediment to innovation and one that’s squarely in the customer’s control: price tolerance.

“U.S. providers may be able to come up with new offerings that provide innovation, but at what price?” says Trowbridge. “They may come up with great ideas but if the price point is off, CIOs won’t buy it.”

CIOs may not start off looking for the lowest price; they may have big ideas about transformation and innovation. But somehow, as they move from RFP to final selection, price almost always becomes paramount.

“First there’s talk about how we’ll be partnered forever,” says NOA’s Kobayashi-Hillary. “But once you get to the final stages of the RFP and the only people left in the room are those competent enough to handle the job, it comes down to price.”

Trowbridge ascribes this process to human nature: “People like watching the vendor grovel and getting them to come down in price. The client deal team comes back and everyone congratulates them on how they kicked the vendor’s butt.” But negotiating the vendor out of a profit helps no one. Says Trowbridge, “You get what you pay for.”

In 2003, Fluor signed a $351 million, seven-year contract with IBM Global Services, one of Big Blue’s hallmark On Demand deals that year. In a press release, IBM said the deal would result in “substantial cost savings to Fluor…the streamlining of numerous core work processes…and flexible usage-based pricing that enables Fluor to access computing resources as needed to support growing businesses.”

How’d that work out?

It didn’t.

“They were not innovating; they were not working as a partner for innovation,” says VP of IS Taylor. But he doesn’t blame IBM alone (which declined to comment on its relationship with Fluor). “We were putting the entire relationship in a place that’s just commodity-based,” admits Taylor. “If you want to say, ‘Give me some value add,’ there was no way for [IBM] to get compensated for that under the contract.” Once price becomes the primary focus, you’re locked in. “If you approached outsourcing as a price play, but now you want innovation, it’s hard to move the provider around to that way of thinking,” says Ed Hansen, partner in law firm Morgan, Lewis & Bockius’s global outsourcing practice.

“You can’t change the business model on them in the middle of the deal.” The provider didn’t build in any governance dollars for innovation, and chances are the buyer didn’t either.

It’s no wonder that the IT leaders who are reportedly most disappointed with the level of innovation provided by their IT service providers originally engaged in outsourcing to cut costs or because of competitive or business pressure, according to CIO’s survey. That was certainly true for Fluor. “We had gotten too big in terms of cost, and we wanted to improve efficiency and consistency globally,” says Taylor. And when measured against those objectives, he says, “outsourcing was the best thing we did.” But it hardly lent itself to outside-the-box thinking.

“You put the vendor in a narrow box when you say we want you to do this well and less expensively,” says David Rutchik, a partner with Pace Harmon. CIOs may have more of a shot at innovation on marquee deals, Rutchik says, “but [innovation] still has to be a function of the customer’s knowledge of his own business and processes, what he really wants, and his ability to articulate that.”

What Happens After the Ink Dries

According to CIO’s survey, impediments to innovation include cultural and communications issues, the lack of skills within the supplier, internal resistance and internal budget restraints. But the simplest reason is that innovation was probably never written into the contract in a meaningful and effective way. Once the vendor’s sales team and the buyer’s procurement group part ways and day-to-day management begins, what the outsourcer is and isn’t legally obligated to do suddenly becomes crystal clear. “That person with the strategic vision no longer influences the behavior of the vendor. The people responsible for the P&L take over and all that great stuff never happens,” says outsourcing attorney Hansen.

“Everyone is in such a rush to get these deals done, they end up disappointed because [they] haven’t had the right conversations,” says Gartner’s Anderson. Even if they have had discussions about “innovation” or “transformation,” definitions remain fuzzy. “[A vendor] telling you they can provide ‘innovative solutions to your business needs’ is the same as them telling you they will ‘implement your system based on proven methodologies,’” says Hansen. “Everyone says it, but it means nothing.”

Even if the two sides do come to a consensus about what’s meant by innovation, building a contract around those definitions is difficult. At Entergy Nuclear, Smith realized that his hopes for input and innovation from SAIC were never going to happen because they weren’t in the contract. “I had a kind of a selfish view of it,” says Smith. “Contract be damned, you know, we brought you in here for a reason and that had to do with what else you could bring to the table.” The excitement he had about SAIC using its nuclear domain expertise to come up with new ideas for IT faded. “All the talk about how they could show us how to do new things better…it never happened,” says Smith. “Everyone turned back to the pure utility view.”

An architectural council set up as part of the outsourcing deal and led by an Entergy CTO and technical leads provided by SAIC did a good job of setting standards but, according to Smith, it never played a role in bringing viable emerging trends to the business. On the occasions that SAIC did present Smith with ideas, “they’d say, Here’s something new, what do you think about it?” says Smith. “The next question was, How much are you willing to pay? That’s not want I want to hear from my value-add buddy. They didn’t understand my business.

“I didn’t expect them to live at the nuclear plant,” he says, “but they could spend a week there.” Smith included SAIC employees in all his own meetings, but the further he went up SAIC’s chain of command, the less they knew. The one innovation for which the business was most hungry—wireless capability—“turned into discussion of SLAs and how to restructure them,” says Smith. “They wanted to set it up so each wireless point was treated the same as a server or router.” (Entergy implemented the wireless project with limited help from SAIC.)

“The further we got downstream from the deal, the more we got over our illusions about what the relationship with SAIC might be in the area of innovation,” says Smith. “We couldn’t figure out how to measure innovation and ultimately we had to decide whether we wanted them to manage the IT utility or innovate, because we weren’t hitting either.”

Willingness to innovate only decreases over time, says BAE’s Fecteau. It’s an open secret that the beginning of the outsourcing relationship is a money-losing proposition for outsourcers; they make it up on the back end. If you try to renegotiate to improve or expand services, the provider puts in a less experienced and cheaper team, says Fecteau. “They can still deliver exactly to the SLA, but there is no thought about improving or innovating,” he says. To get that, “you have to build a new kind of contract.”

Why Small Companies Have an Edge

Sure, companies like GM and American Express may have a lot of clout when it comes to getting their IT service providers to innovate, but CIOs at small to midsize companies shouldn’t despair.

“You may not have the negotiating leverage that a GM does,” says Ed Hansen, partner in law firm Morgan, Lewis & Bockius’s global outsourcing practice, “but you might have the ability to help the vendor break into a new market or build a new business model or become more global.” As a bonus, small organizations may be more capable of working with providers to incorporate new ideas or systems—innovation. “[SMBs] may not have all the built-in procedural barriers to innovation that a lot of bigger companies do,” says Hansen.

One trick Hansen uses to help small-business customers realize their own power is to turn the tables during the getting-to-know-you stage of negotiations. “During the RFP process, customers always ask, ‘Why should I do business with you?’ Instead, they should ask, ‘What is it about us that makes this deal worth it to you?’” says Hansen.

If you’re afraid you’re too small to get the vendor’s attention, say so and see how it responds. “The vendor may say, Let’s be realistic. The money we make on this deal is less than a week’s worth of revenue from GM but it’s valuable to us because of X,” says Hansen. Then, at least, “you know you’re worth more to them than the fees laid out in the contract,” Hansen says. And knowledge is power.

Separate Innovation from Service

That new kind of contract is easier to imagine than write. “I was in one meeting where the vendor sat for what seemed like centuries trying to put an SLA around innovation, saying we’ll provide X number of ideas per month, creating this really detailed governance process in place for how ideas get vetted,” Morgan, Lewis’s Hansen recalls. “It didn’t work.”

“The process that produces [the vendors’] 6 percent margins is well understood and providers are quite happy with it,” says Trowbridge. “They don’t have to think too much. They don’t have to meet with the customer. If they have to show up and engage and innovate, that’s risky.”

Customers will have to break the cycle, and that begins with figuring out what they actually want from the vendor. “It’s ultimately up to the buyer to define what is meant by innovation,” says Gartner’s Anderson. “If you can’t define it, you can’t expect it.” IT leaders at Fluor attempted that with their IBM deal in 2003. “We tried to bake innovation into the contract, from a responsibility point of view,” says Taylor. But the pricing remained inflexible and transaction-based so “it was very difficult to reconcile their invoices with what we thought was their contractual obligation to innovate,” Taylor says. If he wanted IBM to do some R&D work or explore a new technology, there was no efficient way to fund it.

Fluor signed a new contract with IBM last year. “The lesson we learned was that we needed to put a more generic umbrella agreement in place for future innovation,” says Taylor. “There are specific towers of service in the scope of work that are commoditized. But there is also a separate agreement that will enable IBM to provide innovation in all kinds of areas, like virtualization.” The contract includes prenegotiated terms for future innovation around issues of indemnity, risk and intellectual property protection. “If we want to have IBM explore virtual desktops, there’s already a fabric in place. We don’t have to call the lawyers and go through a full negotiation each time,” explains Taylor. “And it’s separate from the rest of the outsourcing, so IBM doesn’t need to get reimbursed through the fees we pay for the commodity activity.” Now Fluor can increase and decrease services from IBM without penalty. “It’s important not to lock yourself in because you don’t get the benefit of innovations that present themselves every day,” Taylor says.

Taylor hopes the fourth time’s the charm. “We understand more about how IBM manages its business,” says Taylor. “And they know more about us.” That’s a good start. “It’s in a customer’s best interest to understand all of the vendor’s warts and what it takes for a vendor to succeed,” says Morgan, Lewis’s Hansen, “instead of thinking, ‘Can we put one over on them?’”

Alsbridge’s Trowbridge estimates that half his clients are interested enough in increasing the innovation provided by their outsourcers to take a chance on shaking up traditional outsourcing processes. “The other half want to stick with that arm’s-length RFP process, the yellow-pad sessions, the focus on price,” he says.

Smith of Entergy Nuclear hasn’t given up. “I want to have a partner that can say, Here’s the utility piece, and we can structure that deal, but then let’s figure out how we can incent this other, innovative behavior as well,” he says. “I get really excited about the idea of a partner that could come to the table with that stuff.”

Entergy, however, has given up for now. The company renewed its contract with SAIC in 2006 but “we lowered our expectations,” says Smith. SAIC, he says, had done a good job managing IT as a utility and cutting costs. When Hurricane Katrina struck, it provided business continuity and disaster recovery services beyond reproach. “There wasn’t a whole lot of discussion about how responding to the storm would affect costs or service levels,” Smith says. “They stepped up and did a dang good job.” That’s the kind of priceless dedication one wants from an IT provider.

But it’s not innovation.

That’s enough for some of Smith’s colleagues. And some outsourcing experts contend that’s the most one can expect. The holy grail, says MIT’s Ross, is that the vendor delivers commodity services so well that the internal IT organization no longer has to worry about delivering those services or managing them and so can focus on innovation itself.

Smith has the option to return to his role as CIO of Entergy Nuclear in a few years. That will be around the time Entergy’s contract with SAIC is set to expire, and it has him thinking. “There has to be an inventive way to incent that innovative behavior as part of an outsourcing contract, or barring that, informal ways to encourage it,” says Smith. “I’d like to push for that.”

Senior Editor Stephanie Overby can be reached at soverby@cio.com.