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High-Cost Fears

November 1, 2006
by Sally Goostrey and Denis Desjardins
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With proper contracts and good relationship management, healthcare companies can achieve flexible, cost-effective outsourcing agreements.

Healthcare organizations have one overarching fear when it comes to outsourcing: high costs. And no wonder. While many healthcare companies generally deal with a fixed-cost structure, outsourcing agreements have earned reputations for escalating costs over time.

Inadequate planning, poorly structured contracts and a lack of outsourcing relationship management often contribute to increasing costs, but can be avoided with proper guidance and practices. By keeping an open mind, healthcare companies can implement successful sourcing strategies.

Factors influencing perception

When establishing an outsourcing relationship with a vendor, pricing established on incomplete data may lead a company to feel misled when the bills based on actual usage and transaction volumes start to materialize. To develop a complete picture of IT costs for comparison with outsource vendor proposals, it is important to prepare a comprehensive internal cost model.

An organization's grasp of its own internal costs heavily influences the perception that outsourcing comes with high prices.

Many companies have an inaccurate or incomplete view of IT spending because of factors such as IT service cost centers distributed throughout the enterprise, potential ongoing support costs associated with current and planned projects, and costs within the business units that will be impacted by outsourcing.

When considering outsourcing options, many companies don't accurately measure ancillary costs such as facilities, benefits, IT growth and employee turnover. Without procedures to track these costs, companies can't adequately predict or incorporate these expenses. When looking at the total cost of providing services in-house, a company assumes the risks of under- or over-investment in technology, staff skill development, tools and processes. When outsourced, the vendor assumes these risks and builds them into its price.

Getting the right alignment

Vendor pricing structure is a key factor in high-cost perception. Companies frequently have difficulty matching their internal budgetary cost view with vendors' unit-based cost breakdown. In stark contrast to a general budgetary view, which consolidates IT costs in budget categories, an outsourcing cost structure clearly defines a resource unit — such as server, PC or network equipment component — and ties an associated unit cost to each. Tracking resource unit costs internally to this level of detail is complex and rarely done.

Relationship management — IT governance

How IT governs an outsourced relationship also affects costs. It is important for IT management to have a strong relationship based on business knowledge when building ties between the outsourcer and the business areas being supported. Often, the resources and effort required to manage an outsourcer are initially underestimated as the team minimizes the client governance required in an effort to make the financial business case look attractive.

In reality, the nature of IT management changes from a technical orientation to a relationship development and business-management function. The IT department must still retain responsibility for technical architecture oversight, IT policy and work management.

Due diligence

Comparing an outsourcing contract's baseline cost with the cost a company incurs internally to do business raises a challenge. If a company doesn't conduct due diligence prior to signing an agreement with a vendor, the contract will likely be out of alignment, with potentially significant gaps or higher support requirements than initially identified in the RFP (request for proposal) process.

Increased costs may result when new equipment, software or supported users are discovered during the transition phase of an agreement. It is important for a company to have a solid understanding of what assets it expects to have supported and the supported user population in order to properly align internal costs to those of the vendor.

A contract for success

Outsourcing agreements that take a pure procurement approach and focus solely on lowering service costs almost always fail. Overemphasizing cost — and negotiating away the service provider's profit margin in the process — ultimately hurts the bottom line. It gives the service provider a disincentive to invest in the deal. Instead, they will be financially constrained to operate at the minimum service level until the company becomes dissatisfied and negotiates a change.

By maintaining a positive attitude during price negotiations, companies build a vendor's willingness to invest in their service offerings. This ultimately adds value, particularly when the outsourcer can improve application availability, user community support and risk management. Being specific about the added value each party anticipates helps to launch a positive and clear relationship. Understanding not only the cost of transitioning operations, but also transformation of services, must be achieved during the evaluation phase.

Preparatory financial analysis — the base case

Base case. A base case is a comprehensive internal financial picture of the IT function used to compare the pricing proposed by the potential vendors. Putting adequate focus on the completeness and accuracy of the base case is critical to a successful outsourcing evaluation.

Clearly identified retained costs. Even after outsourcing, a company will be responsible for certain internal functions. The agreement needs to clearly delineate tasks and responsibilities, establish governance parameters and develop the budget for retained costs.

Industry-standard unit costs. Convert a company's budgetary view of cost into industry-standard unit costs, such as 'cost per help desk call', 'cost per minute of processing power' or 'cost per hour of application development time'. When a vendor's pricing comes back in the same units, this facilitates a direct comparison and accurate gauge of relative performance levels and value.

Open dialogue with vendors. Participating in open dialogue about the base case while in a competitive mode prior to signing a contract gives the vendor a complete picture of a company's environment, and helps it price services accordingly. The highest level of a successful relationship is when the cost of the relationship (the price paid) balances with the value to be derived.

Managing ongoing cost drivers

Well-measured, well-documented cost drivers. The company and vendor must understand the causes of cost fluctuations to manage them effectively. This is particularly important in a healthcare organization, where rates are regulated and cost drivers directly impact the rate structure.

Identified unit price escalators (e.g., COLA). Companies and vendors can build predictability into a contract by identifying what components of the price will escalate based on changes in the business and what the formulas are for determining the new prices.

Managing the relationship

Successful partnerships put significant effort in establishing an agreed-upon management and governance structure when the new operating model is implemented. This helps both the client and vendor to uphold their sections of the agreement and constantly work to meet contractual expectations.

Establishing clear and accurate service levels in an agreement documents expectations, protects against unanticipated pricing fluctuations and helps companies measure a vendor's success. Education and communication with business units is critical throughout the outsourcing process to ensure a clear understanding of the service levels to expect, new procedures to follow and the impact of employee behaviors on vendor costs.

Author Information:

Sally Goostrey and Denis Desjardins are principals at The W Group (Malvern, Pa.), a technology-management consulting firm.

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