I just finished reading a Gartner research titled Contracting for Innovation in Outsourcing, 2010-2011, which outlines their findings on the state of ¬†innovation expectations and results in traditional IT outsourcing contracts. According to the report, the majority of their results came from “contract reviews and innovation workshops at Gartner events”. Not unexpectedly, the results were less than desirable with respect to what customers think of the value of the “innovation” (see definition below) they receive from their outsourcers.

Having spent the bulk of my career at one of the largest outsourcers (EDS), I found their analysis interesting, but not surprising. While at EDS I had the opportunity to lead their Innovation Centers in Redmond, WA and Silicon Valley. Tasked with delivering “innovation” to customers, I can speak firsthand about the challenges of creating value from a very abstract and amorphous subject. In fact, the term “outsourcing innovation” is an oxymoron when it comes right down to it. Here’s a few thoughts on why this is true.

It’s all about cost

Regardless of all the hoopla and hype about outsourcing, in the end it boils down to cost – on both sides of the equation. Sure, there is a lot of talk about service improvement, time to market, flexibility, elasticity, etc. But when it comes right down to it, the customer wants to lower their cost of IT services (operations) and the outsourcer wants to lower their cost of IT service delivery. The other benefits do exist and most customers do enjoy them, but the vast majority of IT outsourcing contracts fall into the “your mess for less” category. For the customer it’s about controlling an already decimated IT budget so they can refocus CAPEX and OPEX to revenue generating lines of business. For outsourcers it’s about leverage – getting the most bang for the buck for people, processes and technology. If innovation exists in this model it’s highly focused on improving service delivery capabilities. Little is left for business-oriented technology innovation spending.

It’s hard to innovate when the customer retains architectural control

In very few situations does the customer relinquish architectural control. While we all like to think that virtualization is abstracting away the need to specify operating systems, middleware and system management tools, it just doesn’t work that way. Most enterprise-level customers are adamant about maintaining control of most, if not all, of the architectural “stack”. While virtualization does help to some degree, there are still many cases where customers dictate the underlying infrastructure specifications – or at least require the outsourcer to maintain consistency of the infrastructure for some given period of time to ensure stability. On the other side of the coin, outsourcers like to extend the useful life expectancy of hardware and software as far as possible. Technology refreshes are painful and expensive. When outourcing agreements were 7-10 years in length these costs could be factored into the economic model and as in most contracts “back-ended” to cover these costs. This is much more difficult with shorter contracts and shorter technology life cycles.

In this report, the term “innovation” encompasses changes in technology and the business.Technological change can refer to specific technologies, such as automation and virtualization,new software applications, communications and/or technologies in specific industries, such asrobotics in manufacturing. Business change can include industry-specific or general changes,such as electronic commerce. The client organization will need to monitor these changescontinuously and keep its management and service provider informed of business and technologytrends and opportunities. Source: Contracting for Innovation in Outsourcing, 2010-2011, Gartner

Innovation is not free

Customers expect it to be, but it’s not. Outsourcers tout that their “leading edge” strategies during the sales cycle, but very few are (were) bleeding edge, or even leading edge when it came to technology adoption. Risk avoidance is a major factor in IT service delivery, and adopting technology before it has “aged in the barrel” is not something most outsourcers are (were) willing to do. Now that all of the traditional outsourcers have been assimilated by the Big Five hardware/software vendors, the story is slightly different. The Big Five actually do have R&D budgets and do focus on innovation. In fact, a colleague of mine at EDS, Jamie Erbes, is now Director of HP’s Services Research Lab. So there is money for innovation in the IT services space. But giving it away is not good business, and as the Gartner report points out, determining a price for innovation is hard to do. So customers continue to maintain their expectation that innovation is part of the deal and all too often they end up unhappy when the outsourcer doesn’t deliver.

It’s hard to measure

Probably the biggest problem with innovation is that it’s hard to define, and it’s even harder to measure. All enterprises face challenges on multiple levels – but most can be categorized as business, technology or services (processes). In any given outsourcing relationship you may be dealing with any or all of the three categories. Most likely the focus is on technology or services in the typical outsourcing contract (IT services or BPM). Even if you have a pretty clear definition of the scope of what innovation will cover, it’s hard to measure progress and even harder to measure end results. Most service level agreements (SLA) focus on uptime/availability, performance (throughput), cost per unit or some other measurable entity. Innovation on the other hand is about the impact of new ideas on one or all of the factors described above. Defining milestones and expected results can often be difficult when the customer is looking for some intrinsic value of which they themselves are not really sure – and haven’t clearly communicated to the outsourcer.

So is there any hope for innovation in outsourcing deals?

The issues outlined above paint a pretty grim picture. The highly competitive outsourcing business is now characterized by razor-thin margins on contracts that are shorter in duration. With the advent of “cloud computing”, the customer now has more (perceived) options for delivering key business applications. Add to that the “cloud in a box” model that the Big Five are offering, and you can see that the opportunity for outsourcers to innovate is becoming slimmer by the day. But all is not lost. There are a few key principles that can be followed that should help outsourcers and customers strike a meaningful balance of expectations and ability to deliver when it comes to innovation.

Have the outsourcer explain their innovation model

Notice I said “model” and not “process”. All too often customers have a false expectation that outsourcers (or anybody for that matter) has a defined process that when followed produces “innovation”. ¬†Innovation is about a free flow of ideas and information, from which new ideas and thoughts are generated. Ultimately these new ideas are solidified into value. There’s no “Point A to Point B” approach that gets you there. But it is important to understand the outsourcer’s views and capabilities with respect to how they approach innovation. A few questions that should be asked…

  • How much is your annual R&D budget? How much of it is allocated to innovation activities?
  • How are your top architects identified, coached and trained? How are they connected to the innovation model?
  • How is your innovation community created and maintained? How broad is it? Does it include customers and partners?
  • In which industry forums and standards bodies do you participate?
  • Do you have a patent management system/process?
  • How do you reward innovation?

In addition to these questions, ask the outsourcer to demonstrate their 2-3 highest impact innovation activities for the last 12 months. If they have to stop and think about it then they’re probably don’t have a very good innovation model in place.

The customer must share their innovation strategy and plan

Assuming that they have one, the customer must start the innovation relationship by sharing the plan with the outsourcer. This can be tricky in multi-sourced deals, but it is a necessity if the outsourcer is going to have any chance of understanding the complete landscape of challenges and business opportunities the customer is facing. Only when the outsourcer has the complete business context can they look at the overall service delivery process and determine where innovation can occur – and how it affects the bottom lines of both companies.

Separate the innovation relationship from the service delivery relationship

While they are closely related, it is important to distinguish between day-to-day service delivery and innovation activities. This has been the rub in most outsourcing deals – customers look to outsourcers to provide innovation as part of the base service. A clear distinction between the two, including a separate agreement is highly recommended. This will bring focus and clarity to the innovation topic.

Tie it to key aspects of the service delivery model

Ultimately the goal of an outsourcing relationship is to improve one or more aspects of the customer’s business – infrastructure cost, service availability, time to market for new services, etc. Unless the customer has a totally separate consulting relationship with the outsourcer to focus on innovation not related to the outsourcing agreement, innovation should be tied to something that both the customer and the outsourcer can impact. If not, then there will be a huge expectations gap driven by a desire of the customer to create something outside the scope of the relationship, and the outsourcer’s need to maintain a static, stable infrastructure and lower costs.

Make it measurable, and expect to pay for it

Even though I said above that innovation is hard to measure, it is critical that some sort of expected outcome be defined for the relationship. Innovation can occur in many areas and many ways, so there are opportunities to define measures for those areas. For example, if the outsourcing relationship includes call center management, then the focus for innovation might be on the way to reduce call duration, the number of abandoned calls, or the number of repeat calls. Remember, innovation is about creating and implementing new ideas and the goal is to “do something different”. In this example, it’s to improve one or more elements of the call center process, which can be measured. ¬†The innovation itself is not necessarily the benchmark for the measurement. This is where many innovation relationships fail – there is an expectation that the innovation “process” itself can be measured.

Once the goals of the innovation relationship have been achieved, the outsourcer should also reap the benefits. If the outsourcer gets paid on the number of calls handled, then reducing the calls through innovation reduces the outsourcer’s revenue stream. The innovation agreement must include incentives that motivate both parties, which often is not the case and why outsourcers prefer to “stick to their knitting” so to speak.

Make it inclusive

Now that the Big Five have gobbled up all the independent outsourcers, this is less of a problem. But even in today’s world outsourcers have to deliver a highly heterogeneous infrastructure – some of which they have little on no control over (from a feature/function perspective). If an innovation relationship is going to be successful then it must include, to some degree, all the elements of the IT service delivery supply chain. This is a tough balancing act, but it is necessary. Most infrastructure providers are hesitant to participate in a “what-if” sharing scenario that requires them to offer up competitive advantage ideas or secrets. This was experienced to a large degree in EDS’ Agility Alliance. But if innovation is going to be successful in a multi-vendor environment then inclusion needs to occur – so hire a really good innovation leader who is experienced in leveraging highly complex, multi-dimensional, competitive relationships.

Create a governance model and stick to it

We all dislike the “G” word as it implies overhead and bureaucracy. But it is a key aspect of innovation. You have to take a disciplined approach to innovation in order to achieve desirable outcomes. Remember though, those outcomes may not produce the desired results – innovation often ends in “failure”. It is key to understand this going into any innovation activity. In order to minimize the impact of the activity, you must have oversight to ensure that focus is maintained, the activity stays on track and precious innovation budgets are protected. Governance is a joint effort, and if partners (vendors) are involved then they must also be part of the oversight. As mentioned above, this requires strong leadership. It’s not about just about project management – it includes balancing, leveraging and exploiting often conflicting interests.

In conclusion…

I don’t want to leave you with the impression that innovation within the outsourcing community does not exist, or at least is a daunting challenge. There are lots of really smart people in the outsourcing world that have done amazing things. But tapping into their insight, passion and energy can be tough when the need and desire to be creative is hobbled by a traditional outsourcing agreement. Understanding that innovation has to be viewed and treated separately is the critical success factor in developing new services and capabilities that help customers leapfrog the competition, improve their customers’ satisfaction, or drive down costs.