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Minimizing Transaction Costs to Drive Value in Outsourcing Relationships

This week, we have been attending the Shared Services and Outsourcing Week in Orlando, Florida to discuss the question of how to drive value in outsourcing relationships, a topic that we find interesting and that means different things to different people.

Of course, there are the typical answers about how to drive value in outsourcing—lowering cost, improving process efficiency, and allowing key resources the ability to focus on high value issues instead of repeatable functions. Yet, there is a component of value that commonly is overlooked but that often is the reason that outsourcing relationships fail: transaction costs.

A deal could be delivering all of the benefits listed above, but if the transaction costs of the relationship are too high, neither party will realize the benefits. In fact, if transaction costs exceed other benefits, it is common to see a deal enter a “death spiral” that can result in disputes, failed service levels, termination, or worse.

The mistake that many outsourcing customers make when considering transaction costs is thinking that such costs cease after a deal is signed. On the contrary, transaction costs really come into play post-signing. In complex relationships, the parties incur transaction costs any time they interact. If that interaction does not net a positive value, then the parties run a transaction cost deficit that can be very draining on the relationship.

Service levels are a good example of this principle in practice. It currently is common for sourcing and legal advisers to advocate fewer service levels in a contract. This is usually good advice, but better advice would be to have the right number of the right service levels. Too few service levels, and the parties will incur significant transaction costs trying to determine if the provider is performing; too many, and they will incur significant transaction costs discussing service levels that yield little or no value.

Additional examples of this principle include overly aggressive governance processes, clauses that cause micromanagement, pricing that does not scale, and pricing that causes the parties to be in constant fee disputes or negotiations—all of which encourage the parties to interact in a way that is costly and under productive.

When designing outsourcing processes or relationships, or evaluating a contract documenting those processes and relationships, we suggest giving a good, hard look at how much the processes will cause the parties to interact. Interaction is a good thing, but if that interaction fails to bring value, then it’s just a transaction cost.

Copyright © 2019 by Morgan, Lewis & Bockius LLP. All Rights Reserved.


About this Author

Edward J. Hansen, Morgan Lewis, Client Technology Transactions lawyer, Business Changes Attorney

Edward J. Hansen brings more than 20 years of experience representing clients in technology transactions that involve significant business change. From the early stages of deals, Ed works closely with clients and their advisers on whole deal advice, often before a request for proposal is sent, and continues his support throughout the engagement’s life cycle.

Eric Pennesi, Morgan Lewis, Technology attorney

Eric J. Pennesi focuses his practice on technology, outsourcing, and commercial transactions. As part of his practice, Eric drafts and negotiates a broad range of agreements in matters including software licensing, e-commerce, data licensing and subscriptions, consulting and services, manufacturing and supply, and strategic alliances and joint ventures.