IT purchasers and providers can achieve win–win outcomes by altering their sourcing routines. Here’s how they can be more strategic about the principles and practices they follow.
Global companies in all industries typically acquire a significant portion of their IT services from external providers. Annual global spending on external IT services is about $900 billion, with companies procuring IT consulting, systems integration, application development and maintenance, and IT-infrastructure-management services, among others.
We can expect spending on IT services to increase as companies explore digital products and business models, and require more and different types of technology support. Indeed, digital transformations typically require higher-order IT capabilities and involve strategic partnerships with providers that supply critical knowledge and expertise along with new technologies and support services.
For a number of reasons, however, IT-sourcing relationships have been difficult to get right. Given the speed at which new technologies and software-development approaches emerge, IT purchasers often struggle to understand how to set realistic objectives and incentives; how to balance multiple priorities relating to cost, efficiency, quality, and innovation; and how to structure governance arrangements to benefit both sides. For their part, IT providers wrestle with similar issues: how best to meet a range of customers’ expectations, how to prioritize objectives and resources to help customers meet their individual needs, and how to create next-generation improvements and innovations for customers rather than just carrying out immediate tasks.
To help executives understand how to answer these questions, we conducted reviews of hundreds of contracts over the past three years. The contracts covered IT-sourcing relationships across multiple industries and regions. We analyzed the contracts along three main dimensions: general terms and conditions, commercial terms and conditions, and governance structure (Exhibit 1).
In many of the contracts we reviewed, the sourcing relationship was not meeting its full potential (Exhibit 2). For instance, greater innovation was a desired goal on both sides but often was lacking, according to the executives with whom we spoke. Such performance gaps exist because of shortfalls on both sides of the partnership.
Our research revealed five obvious but often overlooked changes IT purchasers and providers can make to their sourcing routines that could bridge these gaps and create win–win outcomes. Specifically, they must develop a shared understanding of business outcomes, emphasize the long term, actively collaborate on critical IT architecture decisions, pursue transformation with clear planning and relentless “grit,” and devise win–win contract mechanisms (Exhibit 3). Businesses and IT providers should address all five of these areas if they want to achieve a full spectrum of benefits from IT contracts, beyond just cost. Based on our experience, the value gained by both sides could be between two and four times that of pursuing traditional contracting approaches (Exhibit 4). We believe the best way to break from status-quo practices and relationships is to fully recognize the dynamics at play and devise clear plans to alter them.
Develop a shared understanding of business outcomes
For many IT purchasers and providers, it can be hard to achieve a shared understanding of business objectives. In more than 60 percent of the contracts reviewed, teams had not followed a thorough process for internally discussing desired business outcomes.
IT purchasers faced hard internal deadlines for developing and finalizing contracts with providers. They felt they did not have enough time to engage all relevant business stakeholders in defining the full potential value to be gained from investment in external IT services—whether it be cost savings, increased productivity, or more agility and innovation. As a result, they were often unsure of priorities when setting new contracts or resetting existing ones. In 100 percent of the contracts we reviewed where business outcomes were not clearly defined, key indicators of performance were not exhaustive; they tended to be focused on cost. Hence, they were inadequate for measuring desired business outcomes.
Because they had incomplete information about purchasers’ business priorities, providers were unable to determine how best to allocate talent and resources. And because providers were required to follow purchasers’ standard contracting structures and processes, they were less likely to bring new ideas to the table.
To ensure a shared understanding of objectives, purchasers and providers will need to actively break from time and process constraints. Purchasers should involve end users and business-unit leaders in contract discussions with providers early in the process. Desired outcomes should be captured in a minimum viable contract, with the understanding that there will be further collaboration and refinement on terms over time. At one asset-management firm, IT leaders insisted that the CEO, other C-suite executives, and members of the board be involved in the provider-selection process. Senior business executives were asked to attend supplier visits, and the board received periodic updates on the selection process. When properly informed in this way, business executives and other stakeholders can help contract teams set meaningful short-term and long-term objectives and ensure that enforcing mechanisms are embedded in contracts.
IT purchasers and providers will also need to reimagine the request-for-proposal (RFP) process as a “request for solution” process—an opportunity to jointly identify critical problems and define potential solutions. We observed one provider challenge traditional boundaries: in response to an RFP, the provider went beyond a simple outline of services it could provide; it suggested ways that the purchasing company could form a joint venture with the provider and go to market with a joint service offering. This proposal reframed service provision as an opportunity to generate revenue—an approach that turned heads and established the provider’s credentials with the purchaser. The joint-venture idea was not approved, but the provider eventually was rewarded with the services deal.
Emphasize the long term
Almost 80 percent of the contracts we examined included service requirements that were narrow in scope. They were valid for a particular point in time but left little room to incorporate future needs. Contract teams had estimated the volume of work flow required but had built in few or no options to reset contract parameters midstream based on actual usage. Additionally, it was often the case that purchasers had not considered future IT needs in any depth. About the same percentage of contracts we reviewed (80 to 90 percent) did not include adequate mechanisms for encouraging long-term innovation.
The conventional thinking among purchasers is that contracts implicitly compel providers to innovate and adopt a long-term focus. The reality is that the success of the sourcing process will be measured according to savings in the first year rather than value created beyond that. This was evident in our reviews. Ninety percent of the contracts included commercial terms and conditions that were not mutually advantageous, implying that discussions around these terms and conditions had been focused on the here and now rather than on how to activate longer-term innovation and value.
To unlock long-term vision, commitment, and innovation, purchasers should delineate a range of service requirements and expected volumes at the outset, based on real-world business objectives, but then refine and codevelop the service requirements with providers through regular “hackathons”—gatherings aimed at surfacing new ideas and determining the resources required to act on them.
IT purchasers also need to give providers more visibility into the business and its big-picture goals: What capabilities and technologies could providers bring to the table to help the business achieve its objectives? The agreed-upon contract could include a continuously updated backlog of requirements and options for both sides to shift to alternative work-flow requirements and management approaches when delivery models, the volume of work, or the scope of work changes. Both sides might also agree to a series of checkpoints at which they could reassess and redefine terms. Purchasers could also join providers’ customer-council meetings to understand and influence their long-term direction.
A consumer-electronics company negotiated for such flexibility from core IT providers as it determined the best ways to shift to a cloud-based infrastructure. The company did not want to upend existing operations all at once, so it developed a three-year transition plan with providers. The providers would continue to deliver traditional infrastructure services in the first year while gradually shifting the company’s work flow to a cloud platform in the second and third years. Frequent reviews were built into the process, and both sides agreed that pricing mechanisms would be changed accordingly. The transformation is still under way, but as a result of this arrangement, the purchaser has made significant progress in migrating applications to the cloud.
Actively collaborate on critical IT architecture decisions
Most of the contracts we reviewed contained comprehensive governance plans—detailed descriptions of multilevel forums convened by purchasers, designed to gather input from providers or to review and refine day-to-day processes and tasks. But in practice, providers were mostly kept at arm’s length, with no direct input into important technology and innovation forums—for instance, the architecture-review board.
In our observation, this dynamic occurred, in part, because contract-governance mechanisms were generally designed and agreed upon by teams that were not accountable for day-to-day execution and outcomes—for instance, procurement and legal. The teams’ primary focus understandably tended to be on anticipating potential catastrophes and retaining control rather than on creating long-term value from the sourcing relationship.
Win–win relationships cannot exist when IT purchasers do not treat IT-service providers as strategic partners. To facilitate this partnership, companies can activate a provider-success team that includes sourcing experts, technicians, and business leaders from both the purchaser and the provider. This team should create a seat at the table for IT-providers in forums like an architecture-enablement board, where the purchaser discusses ideas on IT architecture and underlying platform innovation jointly with providers.
In our observation, transformations are less likely to succeed—and changes are less likely to be implemented on the ground—when providers do not have input into purchasers’ decisions about the underlying architecture. In about 10 percent of the contracts reviewed, we saw evidence that IT purchasers were beginning to design contracts to actively involve providers in these types of forums and explicitly asking providers to be consulted or informed in architecture-review boards. Companies could improve collaboration by following Toyota’s genchi genbutsu approach—that is, scheduling go-and-see sessions for purchasers and providers.
A global telecommunications company works with multiple IT providers that support the company’s infrastructure management and delivery of software applications. The telco’s contracts with these providers explicitly define partnership-based governance principles. There is a built-in expectation that subject-matter experts from the IT providers will actively participate in conversations about architecture and innovation. In turn, IT providers have gained greater visibility and have shown greater commitment to ensuring that the IT purchaser meets program-level measures of success—for instance, improvement in service levels or direct impact on fees. This approach has enabled the overall environment to function smoothly, with an emphasis on collaboration and transparency.
Pursue transformation with clear planning and ‘grit’
About 75 percent of long-term IT-sourcing contracts reviewed had language indicating that purchasers expected the sourcing relationship to result in a significantly altered IT landscape. But in most cases, there was limited evidence of a transformation plan or a strategy to get the required investments for changing the underlying operating model. For example, 75 percent of the contracts focused on cost control as a significant transformation objective but had less focus on how to measure progress against their transformation objectives. Any dialogue about transformation plans was typically led and owned by IT representatives rather than business stakeholders. The latter were informed as needed. For their part, providers often were not privy to plans regarding the architecture road map, so they felt they could have little influence on outcomes from transformation efforts. In most cases, neither side was completely clear about the starting point for change, the target state, and the exact path to get there.
IT transformations cannot succeed without two things: a shared commitment to creating change, including the underlying IT-architecture choices, and something we call transformation “grit”—or rigorous and relentless attention paid to planning and execution. Purchasers and providers must jointly design a transformation road map; it is critical that it be codeveloped and co-owned by the business-unit leaders. Purchasers and providers must support this road map with detailed planning to get to a new target operating model. In this way, they can build a baseline against which to measure outcomes from any sort of IT transformation. Contract teams can monitor costs, but they can also track nonfinancial performance-based metrics (for both business and IT activities) such as asset-refresh rates and service-delivery times. Under this approach, IT purchasers can manage change in the IT landscape more effectively (with input from business stakeholders), and IT providers can be assured that their share of gains will be based on a solid business case rather than an ambiguous definition of success.
The contract team at one investment bank set aggressive transformation goals at the outset of its conversations with sourcing partners. The contract team sought a 40 percent reduction in costs in the first two years and an additional 40 percent reduction over the following six years through the use of the provider’s services. These numbers galvanized the bank and the IT provider. They jointly considered unconventional ideas for transforming the bank’s operations—for instance, moving to cloud-based services and retiring some applications—and implemented each according to a detailed plan they had drawn up early in the process. The bank, its stakeholders, and the IT provider managed to reset existing relationships and worked together to push for significant technology improvements over the long term.
Devise win–win contract mechanisms
The reality of IT-services sourcing is that in most contracting relationships, negotiations are treated like miniature battles, typically with each side focused on achieving the best price rather than mutual value. Indeed, in most of the contracts we reviewed, commercial mechanisms were not designed to be mutually advantageous, particularly during large contract resets. Certainly, cost reductions are an important objective for IT purchasers, but those reductions cannot come solely at the expense of providers’ margins if sourcing relationships are to flourish.
Both sides should instead pursue a balanced set of economic incentives. They could ensure sustainable economics by being transparent about underlying sources of cost and by setting mutual targets. Instead of focusing solely on unit prices, they could adopt a total-cost-of-ownership approach to pricing that, at the outset, incorporates all possible costs, consumption patterns, and other factors, given different scenarios. There could be an open discussion about mutual incentives in a scorecard that tracks implementation of gain-sharing mechanisms in the contract. Both sides should also consider the value of the contract over its duration rather than just at the beginning. Some contracts are structured so that one side can meet its business and financial objectives in the first year while the other party benefits in the ensuing years. We found balanced incentives in only about 10 percent of the contracts reviewed.
An automaker struck a deal with the provider of IT-infrastructure services under which it agreed to a certain minimum in annual spending. It also agreed to provide reliable forecasts of service needs for a small group of business activities that were stable and thus easier to predict. In return, the provider offered the automaker commercial discounts and agreed to a gain-sharing arrangement in which both sides would benefit from aggressive productivity improvements.
Similarly, a European telecommunications company struck a win–win deal with the provider of its infrastructure-management and application-development services. Under the terms of the deal, the purchaser would benefit from an aggressive and predefined schedule of productivity improvements that would push unit prices down, thereby counterweighting the effects of inflation. Instead of offering outright volume discounts, the provider changed unit rates every year based on actual consumption by the telco compared with the previous year’s numbers. This helped sustain the volume of work flowing to the provider and allowed it to correctly gauge and meet the required levels of service each year. As a result of these win–win economics, the provider was always willing to address any pain points for the telco during the contract term. The purchaser received reliable service. In turn, the telco’s IT users gave the provider high customer-satisfaction scores.
IT sourcing is not going away. Companies in all industries lack the bandwidth necessary to maintain all their IT capabilities in-house. They must rely, to one degree or another, on external service providers to get even the most basic tasks done. And as more companies attempt to digitize their products and operations, IT sourcing becomes even more critical.
Companies should continually assess the efficacy of their strategic partnerships—they must evaluate not just technologies provided or service-level agreements forged but also the expertise obtained and innovations achieved. Our research pointed to five ways to strengthen IT-sourcing dynamics. There are likely other areas for improvement as well. What’s clear is that both sides will need to view their interactions differently—as true win–win partnerships, where more value from IT is created together than apart.
About the author(s)
Rahil Jogani is an associate partner in McKinsey’s Chicago office, Aditya Pande is a partner in the Silicon Valley office, and Vikrant Shirdade is a specialist in the Gurgaon Knowledge Center.
The authors wish to thank Gaurav Mittal for his contributions to this article.