My kids watch a popular TV show called Mythbusters in which the hosts seek to uncover the truth behind popular myths. While watching it with them the other night, it struck me that outsourcing has its own share of myths. One that I think deserves having a light shined on it is benchmarking. In this article, I’ll discuss the myth around benchmarking, its impact on an outsourcing agreement, what I take to be benchmarking’s proper role, and I’ll endeavor to do it all with the same “gleeful curiosity and plain old-fashioned ingenuity” that the hosts of Mythbusters are described by the Discovery Channel as possessing. Ready?
Benchmarking refers to a process whereby a customer engages the services of a third party expert to review the services in the outsourcing deal with its vendor. The third party expert (the benchmarker) then compares those results against other comparable deals to determine whether the customer is realizing good value. Sounds straightforward; so, what is the myth surrounding benchmarking?
To my mind, there are misconceptions about benchmarking. And, the most significant of those misconceptions is that benchmarking is a substitute for the running of a competitive RFP process. This myth most often materializes in the context of a deal in circumstances in which the customer is under time pressure. A decision is made to sole-source the negotiation with a single vendor, and then rely on benchmarking in order to ensure that “market based” pricing is achieved. Myth #1: benchmarking is not a proxy for the conduct of a competitive RFP process (which by its nature does disclose market pricing).
The Normalization Process
The first thing to understand about benchmarking is that it is equal parts art and science. The straightforward description above of this process belies the difficult exercise of “normalization” – that is, undertaking the benchmarking exercise in order to obtain an “apples to apples” comparison of pricing. Factors that are included as part of the normalization exercise include:
- The state of the customer’s environment – how modern it is may well have an impact of what techniques a vendor may utilize in order to deliver services, how efficient the vendor may therefore be, and accordingly, what the vendor’s pricing is in turn.
- Where the services are being delivered from – the use of different geographical locations require the vendor to remunerate is resources at different levels in order to remain competitive in those marketplaces from a salary perspective. This in turn has an impact on the vendor’s cost base, which is realized as contributing factor the hourly rate charged for those resources.
- The quality of services the customer desires to obtain – the quality of services is inextricably linked to each of the scope of services and the pricing for services. Together, these three elements are locked as a triumvirate. So, for example, if you wish to increase scope, but maintain quality, then typically there will be a corresponding increase in pricing; and if you wish to maintain scope, but increase quality, then again there will typically be a corresponding increase in pricing.
- The scope of services the customer has bargained for – the pricing for certain services where they alone constitute the scope of services for a certain outsourcing may be radically different than the price for those services where they form part of a much broader scope of services in an outsourcing. The difference between these two models is that the vendor may be able to achieve an acceptable level of profitability by cross-subsidizing the price between two or more services under a broader mandate. The healthy margin of profitability it may achieve with respect to one line of service is then used to offset another line that is less (or not) profitable. The broader outsourcing thus permits the vendor greater pricing flexibility than could be realized with respect to the single line of service alone.
There are many more like examples, and all of this is the province of the benchmarker to normalize so that its report results in an “apples to apples” comparison of pricing. Most vendors hate benchmarking; a few have corporate policies in place that preclude their entering into deals that require benchmarking. It’s not difficult to see why vendors have this reaction – a benchmarking clause is used exclusively to lower the vendor’s pricing under a deal, and never to permit it to increase pricing. So it’s all downside for the vendor, or at best, the maintenance of status quo.
The difficulties inherent in the normalization process are what lead me to conclude that benchmarking is not a substitute for a competitive RFP process. But does that mean this concept should never form part of an agreement? If a customer is entering into a long-term outsourcing agreement (5 years in length or more), then I believe some concept of benchmarking is important to include as part of the agreement. The problem the customer faces with respect to the pricing for a long-term outsourcing is to account for the impact of time and associated changes on the marketplace (new technology, new methodologies, new tools, resources, etc.), which, in the absence of a benchmarking clause, would be external to the deal.
However, I also believe that a long-term outsourcing agreement must include other concepts that are also intended to support a customer’s ability to account for time’s impact, such as “continuous improvement” clauses, and SLA review / improvement clauses that entitle customers to set new SLAs and modify existing SLAs within an agreed framework. And, most importantly, a long-term outsourcing should include an annual strategic planning concept in which the customer can describe its intended strategic direction for the forthcoming future, and the vendor can find ways to contribute to the success of that future, including through the utilization of new technology, new methodologies, new tools, resources, etc.
In this way, to my mind, governance takes an increasingly important role with respect to the maintenance of “on market” pricing as part of a long-term outsourcing, as the parties conceptually move closer to an arrangement resembling a strategic alliance. The art in this context is to identify metrics for success that align each party’s interest. This is a point I will cover in my next article in which I seek to bust the myth that what’s good for a vendor must be bad for a customer and vice versa.