the winner's curse in it outsourcing

The Winner's Cursein IT Outsourcing:STRATEGIES FOR AVOIDING

RELATIONAL TRAUMA

Thomas KernLeslie P. WillcocksEric van Heck

Information technology (IT) outsourcing is the practice of contracting out orselling the organization's IT assets, people and/or activities to a third partysupplier for monetary payments over an agreed time period.' IT outsourcingcontinues to experience a phenomenal adoption rate in North America,

Europe, and more recently Australia. Having reached an estimated market sizeof approximately $140 billion in 2001,^ it has evolved into a viahle, yet at timesrisky, management option to handle today's extensive information managementagenda. At the same time, IT services have evolved into a highly competitivemarketplace, with consequences for how suppliers hid and secure contracts,particularly in times of market downturn.'

Indeed, selecting the right IT supplier, on the right terms, poses an ongo-ing challenge. The difficulty frequently lies in choosing the evaluation criteriathat satisfy the client organization's objectives for outsourcing in the first place—commonly those benefits that the internal IT organization is not able to deliver,but that the supplier(s) can offer. The major criteria have been identified asfinancial, business, technical, strategic, and political benefits.* The most commonbenefits sought are financial, typically representing cost savings of between 10%to 40%, improving cost control and clarity, and increasing cash flow. Business,strategic, and political benefits have involved new business start-ups, process re-engineering, a refocus on the client's core competencies, assisting in managingmergers or globalization, and diminishing the often political debates about newIT projects.' Finally, the technical benefits commonly offered have includedaccess to expertise, improved services, new technologies, and technologicalinnovation.* The general lure of ridding oneself selectively or totally of the "ITinvestment pit"—and instead paying a fixed monthly sum for IT services or ona "pay-for-use" basis—remains a major measure for selecting a supplier.

CALIFORNIA MANAGEMENT REVIEW VOL 44, NO. 2 WINTER 2002 47

The Winner's Curse in IT Outsourcing: Strategies for Avoiding Relational Trauma

Although organizations typically outsource for a selected mix of theahove reasons, a client's focus on cost savings can drive supplier organizationsinto making service delivery promises that are initially calculated on a slim oreven nil profit margin. They may do so, for example, hecause they are shortof husiness due to recession, have hecome less powerftil competitively, or area new entrant into the IT services market. Suppliers may also he keen to entera new market segment, want to lock out competitors, have a strategic intent todominate certain market segments, and helieve that they can recoup the invest-ment and broaden margins later. It is precisely in such circumstances that thedanger of a "Winner's Curse" arises, as suppliers make unrealistic biddingpromises to ensure they win the contract, but already know, or subsequentlydiscover, that they are unable to recover their tendering, business, and opera-tional costs for the near future.^

Instead, suppliers take a risk in hoping that they can recover their costsby, for example, identifying service areas that are in need of urgent attentionand/or areas of immediate service provision that are excluded from the contractbut are needed operationally—so meriting excess fees. In addition, suppliers willattempt to offer additional services from their portfolio of technology capabili-ties, service management, and consultancy services over the life of the contract.Since suppher account management will need to concentrate disproportionatelyon recovering costs, and may well be under pressure from its senior managersto make stipulated margins in unfavorable circumstances, it is more than likelythat trade-offs will occur that disadvantage the client. For example, case studiesdemonstrate that when a supplier seeks to decrease its costs, this can result indecreases in service quality and additional costs for the client.* A supplier's dis-proportionate concern for containment of its costs can lead to inflexibility inthe interpretation of the letter and spirit of the contract, which can also lead toadversarial relationships. Thus, operational performance and the client-supplierrelationship will receive less attention and suffer. As a consequence, in Winner'sCurse situations suppliers will likely jeopardize the success and effectiveness ofthe operations and outsourcing relationship as their focus settles primarily onrecovering their costs, and not on developing and maintaining the relationshipand mutual objectives. As Williamson suggests, a supplier would thus likelyundertake opportunistic behavior, seeking to reduce its own operational costs,often at the expense of the client.'

Selecting a Supplier

Selecting a supplier is a costly undertaking in terms of time, effort, andresources. However, the investment in identifying the right siipplier and contractbid is paramount to the success of the overall outsourcing venture.'" Hence, thecriteria that generally informs the selection process is a richly researched area inoutsourcing." Yet we actually know very little about the consequences of a

48 CALIFORNIA MANAGEMENT REVIEW VOL 44, NO. 2 WINTER 2002


wrong selection, including its impact on subsequent post-contract management,the outsourcing relationship, and financial and organizational outcomes.

Typically, the general outsourcing selection process begins in earnestwith the short-listing of relevant suppliers. Common approaches are an openshort-list process, in which clients advertise for suppliers to apply, and a closedshort-list process, in which suppliers are directly approached by clients.'^ Onceshort-listed, suppliers are issued a request for information that outlines thecustomer's objectives, services, assets, transfers, and issues of relevance to itsoutsourcing intention.'' Suppliers respond with their approach to addressing acustomer's outsourcing ambition as well as their own capabilities, track record,reference sites, and associated information.'* Those selected are then "invitedto tender" and issued a "request for proposal." Depending on the company'sapproach, the tender or proposal is commonly the means by which detailed dia-logues and information exchanges are initiated to further narrow down a selectgroup of suppliers, who then bid for the outsourcing deal."

The final selection is then preceded by a phase of careful evaluation of thevarious supplier bids. Practice shows, though, that customers will often choosesuppliers on a subjective basis informed by qualitative issues, especially wherethe quantitative assessment is more or less the same for all bids. Additionally,poor in-house evaluations of costs and services by customers may also mean thatover-promising by suppliers will be initially accepted as a superior bid. In eithercircumstance, a Winner's Curse scenario becomes more probable.

Confronted by a Winner's CurseAs noted, the Winner's Curse occurs when the winner of an auction or

bidding event systematically bids above the actual value of the objects or serviceand thereby systematically incurs losses. Acceptance of a bid in general is aninformative event, and the failure to incorporate such contingent informationinto the bidding strategy can lead to excessive bids and subsequent losses forboth parties. Each bidder must recognize that she wins the object only whenshe has the highest signal. Failure to take into account the bad news about oth-ers' signals that comes with any victory can lead to the winner paying more, onaverage, than the prize is worth, something found to happen quite often in prac-tice.'* The Winner's Curse occurs in normal auctions, in which the auctioneeris the seller or represents the seller and the bidders are the buyers who havevalues for the object(s) sold. The auctioneer is usually seeking a high price forthe object. The Winner's Curse also occurs in procurement auctions (also calledtendering), where the auctioneer is the buyer and the bidders are sellers whoincur costs in supplying the object(s) bought.'^ In that case, the auctioneer isseeking a low price. In this article, we focus on the latter—that is, the Winner'sCurse in a procurement auction of IT outsourcing contracts and its impact onand consequences for the relationship between the customer and the winningbidder.



Auctions have not only been a perennial feature of doing business inmany sectors, but the phenomenon has been increasing with the recent devel-opment of B2B exchanges and on-line auctions. Interestingly, the theory of auc-tions would suggest that the Winner's Curse is asymmetric.'^ The person whowins suffers the curse alone. In normal auctions for physical products, this isusually the case. However, in procurement auctions for contracts and rights inbusiness settings, this is not the only likely outcome. For example, a supplierwinning a "cursed" deal on a B2B exchange may well cut his losses by providinglower quality products or service to the customer. A buyer winning what turnsout to be a cursed deal may well drive a much harder deal—in terms of serviceguarantee rather than price—next time with the same supplier, or the buyermay remove that supplier from the favored supplier list altogether. In all sortsof markets, a Winner's Curse can have consequences for several parties, overmonths or even years. In such circumstances, auctions themselves may wellbe better conceived as relationship-building exercises rather than one-off bids.Therefore, in these situations the auctioneer could assists the bidders in greaterclarity on the auction process and the objects auctioned and its value. Theauctioneer could also take steps to reduce the potential problem prior to theauction or to help the winner after the auction. One illustrative example in anIT outsourcing context occurred in the EDS-Inland Revenue deal, where an IRrespondent said, "If you are minimizing bid costs and not driving incentivesdown for the supplier, you are doing something really rather helpful to thepotential deal down stream. . . . Acting otherwise you can damage the relation-ship irrevocably.""

The Reality of a Winner's Curse in IT Outsourcing

The outsourcing selection and bidding process has strong similarities tosuch auction situations. In IT outsourcing, various suppliers may be asked to bidto provide IT services, even though all too frequently the exact value and servicerequirements cannot be clearly determined. In BP Exploration's undertaking in1992, six suppliers were eventually asked to bid for the offered services in cir-cumstances where the exact future service requirements were not certain.^"Decisive criteria for winning such bids tends to be costs, value-added benefits,technology, expertise, capabilities, and reputation or prestige of bidders.^' Thedifficulty in such bidding circumstances is to select those suppliers that offer thebest deal, and here the focus tends to be on what cost efficiencies suppliers candeliver.̂ ^ The assumptions are that suppliers have sufficient economies of scaleand superior IT management practices to deliver improved services for a cheaperprice, and that the resulting savings are those that the client will benefit from.

One danger is the often large disparity between what suppliers initiallytout in their proposals and what is delivered at the end of the day. In fact, somecompanies and government institutions have found outsourcing services toprovide few measurable improvements or additional benefits;" and in the late

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1990s some have even subsequently terminated contracts early (for exampleAmerican Express, East Midlands Electricity, Sears UK). These and similar casesseem to suggest that suppliers can he overly keen to win a particular deal forpossihle reasons of prestige, size, partnering, costs, and long-term businessopportunities. To reiterate, suppliers' hids may he calculated at cost, leaving avery small margin upon which they can make a profit. Indeed, suppliers mayeven sign a deal or part of a deal almost as a "loss leader," assuming that addi-tional business will arise upon which they can make money. Thus, for example,in its 1993 ten-year deal with the UK Inland Revenue, EDS made losses for sev-eral years running Inland Revenue's data centers. Profitability only emerged inthe late 1990s from the economies of scale achieved by consolidating the IRdata centers with those of the Department of Social Security—a deal also runby EDS.̂ *

Additionally, suppliers often have to bid on the basis of incomplete infor-mation, as the overall IT environment of an organization is often too highlyintegrated to evaluate ohjectively the actual service costs and technical require-ments. IT is also a difficult area to bid for accurately and differs from other typesof outsourcing in several respects. First, IT is not homogeneous but comprises awide variety of activities, skills, and technologies whose differential costs andimpacts cannot easily be assessed or accounted for. This is particularly true inIT development projects, which have so many intangibles. Second, IT technicalcapability continues to evolve at a dizzying pace, making it difficult to predict ITneeds with any certainty. Third, there is no simple basis for gauging the econom-ics of IT activity—there are few industries where the underlying economics shiftas fast as in IT. Fourth, IT value often lies in the cross-functional integration of,business processes and the penetration of IT into the core of organizational func-tioning. Such value is difficult to measure and contract for. Fifth, in-house ITevaluation has an indifferent track record. This frequently makes like-for-likecomparisons of in-house against supplier bids difficult to achieve. For example,in one deal we researched, supplier bids were benchmarked against an estimateof in-house costs that was subsequently found to be 70 percent understated. Allthe factors listed above came together in one telecoms outsourcing deal we stud-ied. On the supplier's calculations, the deal was scheduled to cover its costs inthe first year and move to operational profit thereafter. The supplier actually hada $15 million loss in the first year, a result likely to impact on the client as wellas the supplier over the next four years of the contract.

The likely danger all this implies is that suppliers can out-bid themselvesand subsequently find it impossible to continue with the deal as priced andstructured. This is, of course, only one of many possible scenarios. Figure 1 illus-trates the main possibilities. The supplier experiences a Winner's Curse when itwins the bid but at too high a cost. This can subsequently have either negative(Lose-Lose quadrant) or positive impacts on the client company. On the otherhand, the supplier may win a hid that secures its required profit margin whiledelivering on the client's costs and service expectations (Win-Win quadrant).



F I G U R E I . The Winner's Curse and Other Scenarios in IT Outsourcing

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However, it may also be that the supplier secures its profit margins, but at toohigh a price for the client.

In a Winner's Curse situation, the relationship is likely to suffer severelydue to the supplier's miscalculations. If the client controls the situation tightly,the Winner's Curse may only affect the supplier. However, the situation mayalso result in diminished services, lower number of supplier staff, and less-experienced staff actually in charge of the deal. The client itself may be facedwith the consequences of a Winner's Curse, resulting in significant additionalcosts and the need for increased management input to alleviate the frustrationsof users and staff (Figure 1). Other costs may, for example, also result from notgetting a much-needed new IT system, resulting in a competitive disadvantage.In such circumstances, the question arises whether outsourcing remains viablefor the client or whether a significant return to in-house sourcing defines a bet-ter option. In practice, what makes IT outsourcing distinctive is the high switch-ing costs of such a return. In one deal we examined, a 10-year $550 million dealwas terminated after only 17 months. Additional implementation and termina-tion costs to the client were estimated at $160 million. Not surprisingly, withsuch prohibitive switching costs, many clients may make the judgement that

52 CALIFORNIA MANAGEMENT REVIEW VOL.44, NO.2 WINTER 2002


continuation of a "cursed" outsourcing arrangement may be the lesser of twoevils.

Of course, evidence of such circumstances is rarely publicized andexplicit—but it does exist. For example, a recent academic research study found21 of 85 outsourcing deals in failure mode, but only eight had the contract ter-minated prematurely." The likelihood of such circumstances will increase overtime, as the growing competitive pressure on suppliers (due to the ever-aug-menting IT outsourcing market) will push them to compete increasingly onprices and service deliverables. Following is a first-hand account of a Winner'sCurse scenario, showing how an IT outsourcing arrangement developed into aWinner's Curse for the supplier, which then also cursed the client company. Therelationship was eventually converted into a "No Curse" arrangement for bothparties.

Relational Trauma at Clientco Oil

"ClientCO" is an affihate of one of the largest petroleum companies in theworld. [To honor the company's and participants request for anonymity, all names havebeen changed.] It is an integrated oil company combining the upstream activitiesof oil exploration and production with the downstream activities of refining,research, distribution, and sales. Plagued by ongoing cost and operational effi-ciency pressures, petroleum firms such as Clientco have been driven to focuson their core operations and source other services from the market.

In 1994, Chentco signed a five-year, $8 million selective IT outsourcingdeal with Supplier A for legacy application support services. Clientco only con-tracts suppliers for selective services since, historically, no single supplier hadheen found to deliver all their requirements to required standards. Secondly,careful selection of small niche suppliers ensured that Clientco's business wouldbe of strategic significance to the supplier, assuring greater attention and control.Thirdly, they chose suppliers who closely matched their culture—a key factor intheir outsourcing strategy.

Supplier A's SelectionSupplier A was specifically asked to present a competitive bid against

another suppher (Supplier B), who at the time was contracted to deliver applica-tion support services. Supplier B at the time was the preferred supplier, havingsupplied Clientco with IT services for the previous seven years, but they werealso perceived as expensive. Consequently, Supplier A was implicitly asked tomake a lower price offer, undercutting Supplier B to such an extent that itbecame worthwhile for Clientco to switch.

"They [Supplier B] did it on a day-rate basis and they were the company thatmoved us the furthest forward in terms of proactively showing us how to doapplications support and development better. But, at a cost. This was a Rolls-Royce service."—Senior Manager, Clientco



Supplier A's strong price offer, fuelled by its keenness to acquire businessfrom a 'Blue Chip' company such as Clientco, gave Supplier A the impetus tooutdo Supplier B. However, the low-margin calculation Supplier A made wasto cause much strain in the initial years and consequently raised questions inClientco over whether cost-saving offers procured through a competitive bench-marking or tender process should be scrutinized more closely before actuallycontracting with the competing bidder.

The Specifics of the Deal—The Contract

The 1994 contract with Supplier A was structured into two parts: a coreservice had to be supplied continuously according to service level agreements;and an enhancement service was required that varied according to Clientco'schanging requirements. Pricing of the service provisions was also split into twoparts. Core services were priced on a fixed monthly call fee of $73,000 for alllegacy application and system services. All add-on change requests variedaccording to agreed and accepted prices. However, on average Clientco spentan additional $67,000 a month on service additions and changes. Overall,Clientco was paying approximately $140,000 a month.

The contract was structured to assure Clientco an annual cost reductionin the flat rate charges for the core services. As Supplier A's customer servicemanager stated: "It's reduced by $30,000 the first year, and a further $15,000in each following year." The shrinking the amount of work implied that theservice provisions would become at some point redundant. The planned timefor this was 2004, at which point most applications would be operational on aclient/server infrastructure. In turn. Supplier A's revenues would tail off overthe next seven years. Naturally, this put additional pressure on Supplier A'smanagers to identify new areas of business.

Taking Over the IT Services—Transition Period

The transition period for Supplier A started in earnest in mid-1994, withthe takeover of existing service arrangements from Supplier B, and the applica-tion of their expertise to provide the promised cost reductions. According toClientco, operationalization of the deal was a straightforward matter of deliver-ing what the service level agreement specified. The key difficulty for Supplier Awas that they were taking over from an existing contraaor that was used toClientco's idiosyncrasies and expectations. For Supplier A, it was a new environ-ment. There was no one whom they could initially rely on to help operationalizethe contract—especially not Supplier B, the competitor who had lost the busi-ness. Surprisingly, Clientco's managers were initially not aware of these difficul-ties. Only in retrospect did they recognize the correlation between theiridiosyncrasies and Supplier A's early problems.

"It was a difficult time because they didn't know how we worked, we weren'tsaying to them, 'here's five of our best people, they are going to sit and work with

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you,' because we didn't have five people to work with them. Because the businesshad already been contracted."—Senior Manager, Clientco

Clientco's experience with procuring services informed this policy ofadhering to agreed service levels. In turn, Clientco had invested considerabletime and effort in formulating a detailed contract and service level agreementthat then had to be delivered on.

"It's all laid down in here [the contract]. The systems are all defined as beingeither critical, highly critical, or low criticality. They are graded according to howcritical they are to Clientco and the business. And depending on whether theyare critical or less critical it defines how many hours you can wait before you geta problem fixed."—Application Support Manager, Supplier A

The service level agreement details also simplified the payment system.All payments were dependent on the achievement of the stipulated services.Evaluation occurred on the basis of three main performance measures: downtime, the number of change requests, and the amount of time spent on specificaspects of the core services. The core service levels and their prices were annu-ally renegotiated and updated in an effort to ensure that costs were continuallyreduced and the legacy services slowly phased out.

Working with Clientco was seriously complicated by its strong security,safety, and control-driven culture. This substantially increased the supplier'soperating costs. As one of Clientco's Vendor Managers stated: "We've had anumber of suppliers tell us that our controls potentially add 25% to the cost."

These early adjustment and cultural difficulties led to an initial poor ser-vice performance. This, of course, seriously hampered the development of therelationship. Blame was later apportioned to both Clientco's and Supplier A'soperation managers in charge of the deal. Due to ongoing confrontations, theyhad to be replaced. These changes were very costly for both Supplier A andClientco. Indeed, it was later perceived to be a defining moment in the turn-around of the venture and relationship.

Part of the newly appointed relationship managers' task was to ensurethat Suppher A's structure, and hence managers, were closely matched to theclient's expectations. In this respect, Clientco's relationship managers becamemuch more involved in all personnel arrangements and in the alignment ofSupplier A's structure with that of Clientco's. As a result, managers spent anincreasing amount of time focusing on the relationship rather than on the busi-ness requirements. IT outsourcing success was becoming more and more corre-lated with relationship management.

Chentco had taken the management procedures and processes from itsprevious dealings with Supplier B and merely transferred them to the operationswith Supplier A. It soon became evident that these procedures and processeswould not work with Suppher A. Consequently, Clientco formalized its man-agement reporting processes, outlining senior management meetings at which



supplier performance would be monitored and reviewed. This, in turn, thendetermined what payments were made and whether bonuses were granted.

Renegotiating the Contract

Towards the end of 1995, it had become clear to Supplier A that theywere no longer able to deliver the services as originally priced. For the firstone and a half years they had only made losses. The contract was in fact costingthem significant amounts of money. Services were suffering and both sides werehighly dissatisfied with the arrangement. As a result. Supplier A was forced tore-evaluate the contract and its business with Clientco. In part, they had toadmit to themselves that some of the problems they were encountering, espe-cially the lack of profit, were a result of their erroneous calculations andassumptions about Clientco's business.

"When Supplier A first came into the frame with us, they were very much usedto dealing with public utilities and councils and things like that and they found usvery strange. They came in, they took our business, and they made some assump-tions that we were organized like a council or a utility. We had high overheads, allthose sorts of things. We had excess resources working in that area. But we didn't.We'd already done all that work. They were a little bit naive to start off with."—Vendor Manager, Clientco

In mid-1996, Supplier A was left with no recourse hut to confrontClientco with their partially self-inflicted problem and request an early contractrenegotiation. They had two options for resolving the situation: either renegoti-ate or terminate the contract early. Clientco's response was favorahle, revealingsympathy for and understanding of the supplier's situation. The stated positionwas that they were not interested in causing Supplier A a loss and wanted bothparties to mutually benefit from the deal. Hence, Clientco's management agreedto revisit and evaluate the original contract. Interestingly, they found termsand price scales that essentially prohihited Supplier A from making an adequatereturn on their costs. Reflecting on the original state of the contract, one respon-dent emphasized:

"The contract that was put together was appalling. It did not take into accountthe availability of additional programmers as needed and the very significant pricerises in the market. This thing wasn't tied to Key Performance Indicators, it wasn'tfair, they just couldn't deliver the services for us on it, so we had to go in andmake some changes."—Vendor Manager, Clientco

The procedures adopted for the renegotiation cycle were simple. Whilethe ongoing service delivery was continuing as specified in the initial contract, ateam on Supplier A's side was formed which negotiated the specific changes withClientco's Contracts and Materials department and the Clientco Vendor Man-agers. The ensuing review and renegotiation re-aligned the contract to the pre-sent and actual service demands and also uncovered a numher of stipulatedterms that were unenforceable in business terms.



"There was a review on how much they were paying for core services because wewere doing a lot more core work than we were being paid for at the beginning . . .but also there just seemed to be a lot of unnecessary stuff in the contract whichwe were never going to try and do. It didn't seem to make business sense to do it.So that was taken out."—Applications Support Manager, Supplier A

Once a section had been renegotiated and finalized, the changes werethen taken on board straight away by Supplier A's account team and Clientco'soperational managers. This meant direct implementation and operationalizationof the new terms. At times, the renegotiation phase was a trying time and rela-tions suffered, but it was essential if Supplier A was to be able to continue withthe outsourcing venture. The outcome of the renegotiation was felt to be a verypositive experience for both parties.

Rebuilding Relations—Post-Contract RenegotiationsThe successful outcome of the renegotiation phase put the relationship

back on track. The first signs of the changes to come were the dramatic serviceperformance improvements. These were so impressive that in subsequentmonths relations improved to such a degree that both parties agreed to developthe basis for a partnership agreement. This agreement would cover a number ofoperating principles, but would not embody any legal commitments whatsoever.Instead, it was a rhetorical commitment.

"It's an informal thing but it's been written by both sides. We have a partnershipagreement with them rather than just do this only and only this [contract]. But Idon't think it's actually officially recorded anywhere. It's one of those things thatSupplier A and Clientco do mention a few times, we are trying very hard to workwith Clientco not against them."—Application Support Manager, Supplier A

The informal agreement was based on greater commitment by the sup-plier to inform Clientco of any planned changes that could effect the relation-ship. In a sense, it was an extended promise to cooperate and collaborate moreclosely. The impact of this informal agreement was manifold. For one thing, itincreased willingness for closer cooperation and generated a feeling of opennessand trust in each other. These developments spurred a strong sense of loyaltyon the supplier's side towards Clientco. In fact, the loyalty evolved to define anethical undertone in the operations of the venture.

The benefits of these changes were felt to be of mutual advantage. InSupplier A's case, it gave rise to new opportunities for business not only with theIT department, but also with other business units within Clientco. Another ben-efit for Supplier A was the client IT group's willingness and openness to discusstheir future developments and long-term strategy. It gave Supplier A the muchsought opportunity to bid early for new and upcoming business services Clientconeeded. The benefits for Clientco were increased access to technology, expertise,and skill resources, enabling them to implement projects faster and move theirbusiness forward. More importantly, Clientco began actively to seek value added

CALIFORNIA MANAGEMENT REVIEW VOL. 44, NO. 2 WINTER 2002 57


by offering an additional bonus award if Supplier A could show they had imple-mented additional innovations that added real value or generally improvedClientco's operation.

Strong signs that the relationship and hence operations had improvedbecame apparent in early 1998. Service levels were in line with Clientco'sdemands and in most cases exceeded stipulated services. The relationship con-tinued on this basis for next two years until its contract end. In 2001, the ven-ture was in its second five-year contract period, having never looked back atthe traumatic IT outsourcing years.

Strategies to Avoid Experiencing a Relational Trauma

As noted, research shows that the Winner's Curse is quite common,suggesting that the lessons learned from this case are highly pertinent to all con-templating or participating in IT outsourcing arrangements. From the Winner'sCurse perspective, we re-analyze one of the richer empirical sources available onIT outsourcing, a detailed longitudinal case research database of 85 IT outsourc-ing arrangements across the 1992-2000 period.^* Figure 2 shows these IT out-sourcing deals in terms of the impact of the original bids and contracting terms.

First, the supplier experienced a Winner's Curse in nearly twenty percentof the cases, while the client experienced a negative/mixed impact in nearly 36percent of the cases. Clearly the Winner's curse, and "cursed" clients, are by nomeans rare phenomena.

Second, the left-hand quadrant is a very risky place to be. Of the 12 deals,seven terminated early, one was terminated and restructured, one was notrenewed, and three continued for differing reasons hut were viewed as persis-tently problematic by all respondents.

Third, where a supplier experiences a Winner's Curse, there is a highlikelihood of it also affecting the client negatively. There were three cases wherethis was not the case (top right quadrant of Figure 2). Two (involving a majorUK retailer and an aerospace company) saw the supplier eventually move intoprofit as more work came on stream after the fourth year of these ten-yeardeals. The third was a public sector agency whose gains on an economic devel-opment package with the supplier came to be offset by the cost increases in theIT service aspects of the deal. In all three, the suppliers succeeded in removingthe Winner's curse and moved into more profitable ways of operating.

Fourth, and unsurprisingly, the bottom left-hand quadrant is also not astable place to be. While ten deals did continue to their natural term, althoughproducing very mixed results for the clients, four others were terminated early,three were renegotiated, and two saw slow rebuilding of in-house capabilityduring the course of the IT outsourcing contracts.

By definition, the successful IT outsourcing cases fall into the bottom righthand quadrant of Figure 2. What is most noticeable here is the high propensity



F I G U R E 2 . Prevalence of the Winner's Curse in IT Outsourcing(85 Cases Re-analysed fronn Lacity and Willcocks, 2001)

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of clients to subsequently renew contracts with the same supplier—over threequarters did so—and the disproportionately high number of selective outsourc-ing deals on 3-4 year terms with detailed contracts and service level agreements.How can stakeholders in IT outsourcing ensure they can get into this quadrant,or—more difficult—if an outsourcing deal does not start out here, what can bedone to turn the situation around?

Lesson 1: Suppliers bidding for an IT outsourcing contract may underbid becausethey do not take into account the real value and real costs of the outsourcedactivities. They do not take into account a correction for their own optimisticestimate because their bidding aim is to win the deal.

The initial deal Clientco negotiated was strongly in its favor, but the rela-tionship as such was "cursed." The deal, as agreed, gave Supplier A all too fewpossibilities to recover their bidding expenses and negotiation costs. In fact. Sup-plier A found that the venture would make a net loss to operationalize, as theyhad evidently miscalculated their initial bid offer. It is interesting how Supplier Acould have made such an erroneous cost calculation when competitively biddingfor Clientco's business. The conjecture proposed by the managers at Clientco


The Winner's Curse in iT Outsourcing: Strategies for Avoiding RelationalTrauma

seemed quite plausible—that Supplier A had made assumptions about Clientco'shigh resource-base costs and operational inefficiencies, and then it was unpre-pared to find that Clientco for the past years had been on a drive to minimizecosts and rationalize, standardize, and downsize operations where possible.However, there is another plausible explanation, which is also evident in otherdocumented cases such as Inland Revenue^' and British Aerospace.^* Supplier Aneeded to contract with Clientco to gain credihihty, prestige, and references byworking with a major Blue Chip organization. To Supplier A, essentially a smallniche supplier, such a deal held perceived benefits beyond solely making a mar-gin on that contract. A third contributory factor was that the bid team waslargely different from the group that was charged with operationalizing the con-tract and was rewarded on a different basis, namely, on securing the contractand not on operational performance. The learning points are:

• Analyze carefully the reasons for a low supplier bid and whether the bidcan result in a reasonable profit for the supplier.

• Both the supplier and the client should ensure that those operationalizingthe contract are influential in the vendor selection and bidding process.

• Reassess the cost/service haseline before outsourcing, and make detaileddisclosure to the bidders(s).

• Fixed-price contracts will create inflexibilities, possibly disadvantageous toboth parties. In fact, there is substantial literature pointing out the typicalproblems experienced with fixed-price contracts even in the IT outsourc-ing field.^' Consider flexible-pricing options, including cost plus, marketpricing, fixed fee adjusted by volume fluctuation, and benefit sharing.Track supplier costs via "open book" accounting. Allow for biannualassessment of pricing adjustments.

• Undertake a rigorous due-diligence process before the contract is actuallyfinalized.

Strategic Lesson 2: A Winner's Curse for suppliers can result either in a negativeimpact for the client—resulting in relational trauma, renegotiation costs, and end-user dissatisfaction—or in a positive impact for the client when the supplier incursthe losses and delivers the services to the agreed levels.

Its miscalculations cost Supplier A dearly in the initial one and a halfyears to such a degree that they were left with no other option but to ask foran early renegotiation. At this stage, Clientco could have responded by insistingthat Supplier A honor the contract or pay a termination fee, but they were notinterested in going down a track of complete relational failure and possible highmedia publicity, and instead they decided to renegotiate the contract. This rene-gotiation proved beneficial for both parties, as services improved considerablyand Supplier A in parallel was beginning to make a marginal return. The caseemphasizes that a balance needs to be struck between service levels and costs.The goal must he win-win, where the supplier can make a return. In a one-sided



venture, the supplier has to try to cover its costs in any way possihle, which islikely to effect services, operations, and relations adversely. In addition, in situa-tions of competitive bid circumstances, the client generally has to ensure thatthe supplier is fully aware of the extent of the service requirements, and theclient may have to spend more time on evaluating the bid proposals to avoidhaving to invest in costly renegotiations after such a short period of operation.The learning points are:

• An outsourcing contract will rarely he delivered satisfactorily where thesupplier stands to make a loss, because this will tend to have detrimentaleffects on the service delivered and will sour what could otherwise haveheen a synergistic relationship.

• Renegotiation and restructuring may he hetter options than terminationand high switching costs (see below).

• Conceive the hid as being about a relationship over time, rather than aone-off win or loss.

Strategic Lesson 3: Relational trauma in IT outsourcing can he overcome byinitiating early contract renegotiations. Such a strategy will change serviceperformance and the nature of the relationship, will affect the managementstructure, and will improve operational ejficiency.

Significant impacts on post-contract management and operations wereidentified in areas of contract achievement, management structure, relationshipatmosphere, and operational efficiency.

Contract Achievement

Unexpectedly for Clientco, service levels plummeted significantly duringthe transition period. They remained below target and satisfaction levels for overa year. End-users commonly expect that the supplier comes in and services thenimprove dramatically, not least where there is pent-up demand from previouscost containment, as at Clientco. Often these expectations are not achievedand instead take an unexpected downturn, and Clientco's case is no exception.Adjusting to new processes, systems, and corporate cultures takes time. As thecustomer service manager from Supplier A noted:

"The specific stage when the trust went down is when we started, and it'sextremely hard to provide a service, whatever the level of personnel is, whenyou don't understand the systems. Obviously, systems are very different withindifferent companies. Technology is the same and ideas of how systems work arethe same, but the actual specifics are very different. So when you come in coldand start to provide the service from nothing then the user will see a dip in theirservice from the previous supplier to you."

However, contr'act achievement was always going to he very difficult, asagain Supplier A had made a number of assumptions about Clientco's operationsand requirements that, actually, did not apply—especially in terms of rational-

CAUFORNIA MANAGEMENT REVIEW VOL.44, NO.2 WINTER2002 61


ization and standardization. It is conceivable that Supplier A was not fully awareof the systems and applications they were to take over and, more importantly,that they lacked some of the competencies and resources to actually deliverClientco's service levels. The degree of miscalculation made by Supplier Aseemed to corroborate this fact, as did the lengthy period for the actual consoli-dation and eventual transfer of the systems to Supplier A's headquarters. Thisemphasizes once again the importance of the customer evaluating the supplier'sresources, skill sets, and assumptions regarding their business.

Management Structure

Selective outsourcing for cost containment on a relatively short-termcontract is not commonly associated with detailed relationship management con-siderations—due to the typically stable IT activities and contractual clarity ofwhat is outsourced. In Clientco's case, though, active relationship managementbecame critical. Due to the Winner's Curse scenario in the deal. Supplier A wasprobably not willing to resource the venture with its most experienced man-agers—as a small niche supplier, it most likely needed them as a sales team toattract new business. In turn, during the first year, the existing account managerfound it very difficult to pick-up from the previous supplier and turn the rela-tionship around. His problems in managing the relationship led, instead, to log-gerheads with Clientco's manager. Therefore, Clientco requested a new manager,who then faced off against two newly appointed relationship managers—thereason being that Supplier A obviously needed more active management. Thiswas a decisive step to save the venture.

The impact of a soured relationship, and consequently having to changethe management team at such an early point, was very dramatic. In many ways,it meant starting all over again in developing rapport and relations. For SupplierA, though, these changes meant improved cooperation and support in helpingthem to adjust to Clientco's idiosyncrasies.

Relationship Atmosphere

Clientco's extensive experiences with procuring products and services ledthem to adopt a contract-controlled, power-wielding approach. In this situation,the control approach failed and led to the breakdown of relations. What SupplierA needed initially was some guidance in understanding Clientco's operations.The parties needed to worked together to clarify Clientco's requirements andidiosyncrasies, and this was clearly missing. The results were evident in theamount of confiict between account managers and were disastrous for both par-ties. Service levels were low and Supplier A was losing money.

Improvements came with the introduction of the vendor managers whoseemed to be interested in helping and cooperating to ensure both parties mutu-ally benefited from the venture. In fact, Clientco's managers quite deliberatelyfocused their initial efforts on resolving Supplier A's problems with Clientco,and so began to build trust and cooperation. Only in this kind of context could



Suppher A have gathered sufficient momentum to actually approach Clientco torequest an early contract renegotiation.

Operational Efficiency

The lack of a reciprocal profit for Supplier A contributed to the deficientservice levels. Only through early renegotiation was this alleviated, which ofcourse introduced considerable extra costs for both parties. The renegotiationprocess assured that both parties eventually made a return on the venture andsaved Supplier A from having to terminate the contract, which would have beendisastrous for both parties. In fact, the renegotiation helped improve relations tosuch an extent that other value-added benefits have since emerged from theventure for both Clientco and Supplier A. In the long term, Clientco's opera-tional efficiency improved.

The learning points are:

• Employ early end-user expectation management on the client side, espe-cially during the transition period.

• Ensure that the contract management culture is conducive to supportingsuperior supplier performance.

• Review the in-house core management capability and skills needed formanaging external supply. Build informed buying, contract monitoring,contract facilitation, and vendor development roles from the beginningof the contract.

• Ensure that the relationship dimension is managed to advantage. A con-tract is not a substitute for effective relationship management.

Strategic Lesson 4: A Winner's Curse can be avoided by a supplier throughinformation gathering and bidding activities.

The case findings identified a number of issues that a client organizationcan infiuence in order to avoid or at least minimize the impact of a Winner'sCurse (see Figure 3). In line with general outsourcing practice, these considera-tions filter into a client organization's evaluation, selection, and negotiationstrategy. The objective should be to control their effect on post-contract manage-ment and on the relationship.

It was evident that Supplier A suffered from having insufficient informa-tion to make an adequate assessment of Clientco's requirements. The problemclearly was that Supplier A was under time pressure to make an offer for a set ofservices that had for the previous seven years heen delivered by Supplier B. Theexisting supplier knew exactly what the service provisions would entail, whereasSupplier A had to rely on information only partly made available by the clientand the direct competitor. The resulting assumptions underpinning Supplier A'shid were based on incomplete, incorrect, and outdated information.



F IGURE 3. Supplier Perspective on the "Winner's Curse"

InformationGathering

Causes

• Insufficient Information

• Misinformation

• Wrong Assumptions

Adverse Case Outcomes

Information Congestion

Bidding ' Misaligned Bid Offer

' Bidding To Win, No Matter

' Under-Estimate of Resourcesand Capabilities Required

Above Baseline Cost/No PossibleProfit Margin

Operating ' Under-Estimate of Rigidity ofContract

' Over-Estimate of Extra Work andExcess Eees Available

' Under-Estimate of Control andTightness of Client ContractManagement

Revenue Enhancement TacticsCurtailed/Opportunistic BehaviorMinimized

Clearly, a client can play a more active role in evaluating the bid suppliersmake, especially in one-to-one competitive bidding circumstances, to preventpossible miscalculations of the baseline costs. Interestingly, Clientco's cultureof cost efficiency and tight control was perceived as a protection, but ultimatelybackfired to produce undesired results. Client organizations should ensure thatsuppliers have a reasonable profit margin in their deal. Otherwise, the focus onthe supplier's operations will be solely on where it can recover its bidding costsand begin to make a margin, and the supplier will then seek to save onresources, as happened in this case.

The key point is:

• Supplier information gathering activities are vital. The client should checkto ensure that the bidders are undertaking the detailed information gath-ering activities necessary to present a bid that will be effective in opera-tional terms.

Strategic Lesson 5: The Winner's Curse can be avoided by building contingenciesinto the contract and by choosing the appropriate format for the biddingarrangements.

The bidding phase is often a one-sided event that should actually demandmore active participation by the client—especially in terms of assessing the sup-plier's overall resource potential, capabilities, skills, information access, bid offer,and cost calculations. Intervening early on can help avoid the Winner's Curseand its subsequent adverse impact on the relationship.


The Winner's Curse in IT Outsourcing: Strategies for Avoiding RelationalTrauma

A key factor is the choice of bidding arrangements, namely, whether touse a single-round or a multiple-round sealed-bid format. The critical distinctionbetween formats is that a multiple-round scenario provides the bidders withinformation through the process of bidding. However, this information oftenturns about to be a double-edged sword.'" It can stimulate competition by creat-ing a reliable process of price discovery and by allowing efficient aggregation ofitems. On the other hand, the information could be used by bidders to establishand enforce collusive outcomes. Ex ante asymmetries and weak competition—asin the Chentco/Supplier A case—favor a single-round sealed-bid design. In othercases, a multiple-round bidding arrangement is likely to perform better in effi-ciency and revenue terms.

For the client organization, the learning points are:

• Assist the supplier with information gathering.

• Maintain tight control initially but work flexibly where contract and ser-vice metrics are outrunning market prices.

• Check market prices regularly and huild price recalculations into the con-tract.

• Carefully consider the bidding format. In different circumstances, a single-round or a multiple-round sealed bid will be more appropriate.

Strategic Lesson 6: Identify the relationship implied by the contract and how it cansupport the service and value-added that is expected from a supplier

Previous studies have shown that a strong relationship exists between thea client organization's strategic intent, the kind of technical capability it neededto employ, and the type of relationship needed to match strategy to suppliercapability and achieve expectations. There are frequent misperceptions on thepart of all parties as to the nature and expectations of the relationship.

The main types of IT outsourcing relationships are classified in Figure 4.Strategic intent, in terms of expectations from outsourcing, is divided here intowhether the focus is on achieving business value or on achieving IT efficiencies.On the horizontal axis, technical capability refers to choosing an external sourceto gain a distinctive technical leadership or to gain access merely to technicalresources from a resource pool. The matrix sets up four possible relationships.The most common is the Technical Supply relationship, where the objective isto achieve IT efficiencies by hiring external resources. In such a relationship,the focus is on cost minimization and the rendering of IT as a variable cost. Asat Clientco, the major concerns center on the cost-service trade-off and accom-panying measurement systems.

Another possible relationship is Business Service, where the objectiveis to use an external IT supplier who not only delivers more IT efficiency forchanging business requirements, but is involved in business process improve-ment projects. A third type of relationship is Technology Partnering, where sup-pliers are chosen for "best-in-class" capability, "future-proofing" on the



F I G U R E 4. Strategic Intent and Capability in IT Outsourcing:

Identifying Relationships

zuoui

IMI/I

II

.2

TECHNICAL CAPABILITY

'Resource Pool"Distinctive Technical

Leadership"

"Business Service"

• Underpinning BusinessRequirements

• Supporting Internal BusinessImprovements

• Pay-per-Supply and onBusiness Results

"Technical Supply"

• Cost/Service Trade-off

• Cost Minimization

• Pay-per-Supply

"Business Alliance"

• Profit Generation

• Competitive Edge/StrategicContribution

• Shared Risk/Reward

"Technology Partnering"

• "World-class" Capability

• Innovation/Development

• Technology Risk Sharing

technological front (keeping the client abreast of leading-edge technology), andpro-active innovation in technological applications. Finally, all too many large-scale outsourcing arrangements are presented as Strategic Alliances, whichassumes working together and sharing the risks and rewards. The focus here ison business expansion. Several authors found many so-called strategic alliancesin IT outsourcing to be largely fee-for-service contracts; moreover, the risk-reward elements were too small a part of the relationship to have made a differ-ence in terms of motivation and focus."

Clarifying these options, and when they are most suitable, is an importantpre-condition for establishing the right relationship mechanisms and evaluationregimes. All too many organizations contract and manage tightly for cost effi-ciency, but then also expect the sort of business value-added that can only beobtained from a Business Service relationship or the technical innovation andpro-activity that can only be provided through Technology Partnering. Theframework in Figure 4 can help a client think through its IT outsourcing goalsand what the implications of this analysis might be for relationship arrange-ments and assessment regimes.



The learning points are:

• Even a Technology Supply outsourcing arrangement needs to be staffedand managed for its relationship dimension.

• A Technology Supply arrangement will severely inhibit the value-addedcomponent inherent in the other three forms of relationship.

• If the right core IT capabilities are in place, the relationships developedin a Technology Supply arrangement can lead to more opportunities forenhanced benefits than in any of the other three outsourcing regimes.

Conclusions

The experience of a Winner's Curse places considerable pressure on anoutsourcing venture and relationship to the point where re-negotiation or earlytermination become the only options. Active relationship management by com-petent relationship managers can facilitate a successful turnaround of such aventure. However, regardless of whether the venture is saved, significant costswill arise for both parties, raising general doubts over the financial viability ofsuch deals in general. Understanding how such scenarios can evolve is startingpoint for avoiding a Winner's Curse experience.

As the Internet evolves into a powerful and reliable infrastructure forelectronic commerce and electronic business, new configurations are possibleand feasible. Application Service Provision, for example, is seen by companiesas a potentially profitable business model. In these new configurations,relational trauma could similarly occur and the lessons identified here shouldbe considered before signing netsourcing contracts.

Notes1. L. Loh and N. Venkatraman, "Diffusion of Information Technology Outsourcing:

Influence Sources and the Kodak Effect," Information Systems Research, 4/3 (1992):334-358; M.C. Lacity and R. Hirschheim, Information Systems Outsourcing: Myths,Metaphors and Realities (Chichester: John Wiley & Sons Ltd., 1993). These tworesearch studies present the first in-depth analysis of IT outsourcing practice inthe industry and provide a useful overview.

2. International Data Corporation, European Outsourcing Markets and Trends, 1995-2001, London, UK, 1998.

3. D. Feeny and L. Willcocks, "Core IS Capabilities for Exploiting IT," Sloan Manage-ment Review, 39/3 (Spring 1998): 1-26; J.F. Rockart, M.J. Earl, and J. W. Ross,"Eight Imperative for the New IT Organization," Sloan Management Review, 38/1(Fall 1996): 43-55. Both provide their view of what the core capabilities are forIM management in the 1990s and beyond. An essential tool being outsourcingand using the market for services.

4. A. DiRomualdo and V. Gurbaxani, "Strategic Intent for IT Outsourcing," SloanManagement Review, 39/4 (Summer 1998): 67-80; M.C. Lacity and L.P. Willcocks,"An Empirical Investigation of Information Technology Sourcing Practices:Lessons from Experience," MIS Quarterly, 22/3 (September 1998): 363-408. In



these articles, the researchers present what best practice has shown to define anoutsourcing strategy.

5. K. McLellan, B. Marcolin, and P. Beamish, "Financial and Strategic MotivationsBehind IS Outsourcing," in L. Willcocks and M. Lacity, eds.. Strategic Sourcing ofInformation Systems (Chichester: Wiley, 1998); M. Sobol and U. Apte, "OutsourcingPractices and Views of America's Most Effective IS Users," in L. Willcocks and M.Lacity, eds.. Strategic Sourcing of Information Systems (Chichester: Wiley, 1998). Thesetwo papers provide an insight into global drivers and motivators behind IT out-sourcing.

6. T. Kern and L. Willcocks, The Relationship Advantage: Information Technologies, Sourc-ing and Management (Oxford: Oxford University Press, 2001). See also M. Lacityand L. Willcocks, Global Information Technology Outsourcing: In Search of BusinessAdvantage (Chichester: Wiley, 2001).

7. Ibid.8. Ibid.9. Williamson noted that social actors will behave opportunistically if it is advanta-

geous for them to do so. This opportunism denotes the capability and willingnessof organizations to pursue their own interests at the expense of partners by with-holding, for example, information. O.B. Williamson, Markets and Hierarchies: Analy-sis and Antitrust Implications, A Study in the Economics of Internal Organization (NewYork, NY: The Free Press, 1975).

10. R. Klepper and W. Jones, Outsourcing Information Technology, Systems and Ser-vices (Upper Saddle River, NJ: Prentice Hall, 1998).

11. Ibid.; Lacity and Hirschheim, op. cit.12. V. Michell and G. Fitzgerald, "The IT Outsourcing Market-Place: Vendors and their

Selection," Journal of Information Technology, 12/3 (1997): 223-237.13. J. Cross, "IT Outsourcing: British Petroleum's Competitive Approach." Harvard

Business Review, 73/3 (May/June 1995): 94-102; R.L. "How Continental BankOutsourced Its 'Crown Jewels,'" Harvard Business Review, 71/1 (January/February1993): 121-129.

14. Cross, op. cit.; Michell and Fitzgerald, op. cit.15. Cross, op. cit.; Huber, op. cit.16. P. Klemperer, "Auction Theory: A Guide to the Literature," Journal of Economic

Surveys, 13/3 (1999): 227-286.17. Ibid.18. This point is made by one of the anonymous reviewers and we greatly thank

him/her for this suggestion.19. Quoted in L. Willcocks and T. Kern, "IT Outsourcing as Strategic Partnering: The

Case of the UK Inland Revenue," European Journal of Information Systems, 7/1(March 1998): 29-45, at p. 41.

20. Cross, op. cit.21. Cross, op. cit.; K. Davis and L. Applegate, "Xerox: Outsourcing Global Information

Technology Resources," Harvard Business School case 9-195-158, 1995; Willcocksand Kern, op. cit. All discuss and present an in-depth case study of how organiza-tions decided to outsourcing their IT. They carefully present the decision, vendorevaluation, selection and contracting process these firms went through.

22. Lacity and Hirschheim, op. cit. Ang and Straub show how they employed transac-tion cost theory to investigate IT outsourcing. S. Ang and D. Straub, "Productionand Transaction Economies and IS Outsourcing: A Study of the US BankingIndustry," MIS Quarterly, 22/4 (December 1998): 535-552.

23. Kern and Willcocks, op. cit.; Lacity and Willcocks, op. cit.24. The example is cited by Lacity and Willcocks, op. cit., p. 134.



25. Lacity and Willcocks, op. cit. See also T. Kern, M. Lacity, and L. Willcocks, Net-sourcing: Renting Applications and Services Over a Network (New York, NY: PrenticeHall, 2002).

26. The authors make available the case study data on an open web site. It is thisdatabase that we draw upon here, together with details of the cases from thewritten published sources. The latter are rich enough to permit an analysis of theinitial deals, and of subsequent outcomes. Lacity and Willcocks, op. cit. The website is <http://www.umsl.edu/~lacity/cases.htm>.

27. Willcocks and Kern, op. cit.28. Kern and Willcocks, op. cit.29. See, for example, R. Klepper and W. Jones, Outsourcing Information Technology,

Systems and Services (Upper Saddle River, NJ: Prentice Hall, 1998); P. Strassmann,The Squandered Computer (New Canaan, CT: Information Economics Press, 1997).In the more general theory of the firm literature, see P. Milgrom and J. Roberts,Economics, Organization and Management (Upper Saddle River, NJ: Prentice Hall,1992).

30. See Peter Cramton, "Ascending Auctions," European Economic Review, 42/3-5(May 1998): 745-756.

31. Lacity and Hirschheim, op. cit.; Ang and Straub, op. cit.
