BOSTON (06/15/2000) - After abandoning a life of fasting and meditation for the material world, the title character in Hermann Hesse's Siddhartha takes a job assisting a successful merchant, Kamaswami. Although Siddhartha has a knack for business and customer service, Kamaswami still questions his true dedication to increasing the merchant's profits. A friend advises the merchant, "Give him a third of the profits of the business which he conducts for you, but let him share the same proportion of losses if any arise. He will thus become more enthusiastic."
This sort of atypical pay formula, described by Hesse nearly 50 years ago, characterizes a contract signed in December 1998 by Chicago-based outsourcing vendor Debis IT Services North America and Freightliner Corp., a heavy-truck manufacturer headquartered in Portland, Oregon. The five-year, US$70 million contract is based on what Freightliner estimates it would have spent over that period on the IT operations it is now outsourcing to Debis. Nothing surprising there. But Freightliner pays Debis only a baseline amount to cover the vendor's costs. Any profit depends solely on Debis generating savings. When Debis saves Freightliner money by performing the IT functions for less than Freightliner would have, the two companies split the savings based on an agreed-on percentage.
While neither Siddhartha, Kamaswami nor his friend had a name for this split from the traditional fee-for-services pay structure, it's what we now call gainsharing. Like the merchant Kamaswami, more and more companies are wanting their Siddharthas' livelihoods to depend on their success.
"There's much more dialogue about it now than there was before," says Linda Cohen, managing vice president for sourcing strategies management at Stamford, Conn.-based Gartner Group. "Our clients like to talk about it," she says, "because the buyers want the vendors to have some skin in the game."
In a white paper on outsourcing, Peter Bendor-Samuel and Kathleen Goolsby predict a rise in the adoption of a number of corporate structures--like contingency pricing, cosourcing and joint ventures--that all include elements of gainsharing. "Companies no longer view outsourcing solely as a business tool with cost to one partner being the revenue of the other," she says. "They realize that cooperation and collaboration in outsourcing relationships can lead to gain for both partners." In short, they see a movement from straight outsourcing--when a vendor does something for a buyer--to some type of gainsharing--when the vendor does something with a client, says Bendor-Samuel, editor of the Outsourcing Journal and president of Everest Group in Dallas.
Why this growing corporate interdependence? Stan Lepeak, a vice president and senior analyst at Stamford, Connecticut-based Meta Group, believes the increased interest in gainsharing is twofold. "First, people are becoming more comfortable with outsourcing in general," he says. "They're outsourcing more critical processes and getting creative about pricing." Second, buyers are increasingly scrutinizing the services for which they're paying vendors. "A lot of people have gotten in trouble for handing over the checkbook to consultants," Lepeak says. "They feel they've been overcharged--burned in the past--and are looking for a way to attach pricing to value gained. They see gainsharing as one way of holding people more accountable."
BIG TRUCKIN' DEAL Debis first approached Freightliner about entering into a partnership in early 1998. "Their timing was very good," says Freightliner CIO Rob Hassell. "When Debis CEO Rick Wargo called on us, we were looking to lower costs and upgrade capabilities." Freightliner had a number of proprietary systems that needed to evolve--software that allowed more than 500 North American Freightliner dealerships to support their customers in the 24/7 transportation environment. Also, Freightliner was growing dramatically and wanted to improve IT infrastructure deployment and management for the dealerships. But the company also wanted to reduce the costs of those operations for itself and its dealers. Hassell says what won him over was Debis' uncommon gainsharing proposition--asking no flat fee for its services, only its baseline costs plus a portion of the savings that resulted. This, plus the painless way Debis acquired its understanding of Freightliner's business needs, convinced him to work with Debis. "They offered to do a free market study to help us get our arms around what the opportunities were," Hassell says. "The whole package was innovative marketing on their part."
What made the proposal go down so easy was Freightliner and Debis' shared parentage. At the time the contract was signed, Debis, a subsidiary of Debis Systemhaus in Stuttgart, Germany, was a wholly owned subsidiary of DaimlerChrysler AG, as is Freightliner. Hassell says that because the two companies were related, Freightliner shared information with Debis during the exploratory phase that it might not have disclosed to an outside vendor--such as details about the support applications that differentiate Freightliner from its competitors. But Hassell adds that having the same parent doesn't lessen the risk associated with gainsharing, "because the only way that Debis gets paid is if we make money."
The contract transferred to Debis the ownership and operation of the dealership system servers, network and the client devices. Application development and related help desk chores remain with Freightliner, though the truck maker forwards to Debis all infrastructure help desk items.
In its analysis of Freightliner's infrastructure, Debis calculated Freightliner's baseline costs for providing IT services to dealers and their customers. "We identified what it actually cost them to deliver these services," says Debis' Wargo, "and then asked ourselves, 'How much less can we get it done for?'" He says Debis arrived at a cost per seat that it used to compare the vendor's costs with Freightliner's. To make any profit, the outsourcer must deliver a cost per seat that is less than Freightliner's baseline by certain percentage benchmarks each calendar quarter. While neither side will disclose the quarterly percentage savings they have already achieved, both say Freightliner's savings has increased every quarter. The pair is coming to the end of its fifth quarter and both parties expect more savings. Should Debis fail to effect a savings in any quarter, Freightliner would still pay Debis' actual costs to deliver the service, but Debis wouldn't earn any profit.
In spite of that possibility, Wargo is confident because of the economies of scale he says Debis provides and its experience in procuring vendor services (like telecom hookups and hardware) for less.
But cost isn't everything. Debis must also surpass the service level Freightliner achieved when it ran its own show. "We're not going to get paid," says Wargo, "if we answer help desk calls every other week." Debis' role--managing and maintaining the interface between large fleets of trucks and drivers, dealers and Freightliner--is crucial to Freightliner's profitability.
"The thing to remember," says Wargo, "is that these trucks are capital equipment; they're not like our cars. If our car breaks down, we can take the bus or get a ride to work, and we still get paid our salaries. But the dealer's customers are owner-operators who don't have that flexibility. If their trucks are not running, they're not making money. So getting the fleets what they need, through the dealers, is paramount."
More gainsharing is expected when the partners combine efforts to migrate dealer apps from their traditional client/server platform to a thin-client, Internet browser-based architecture later this year. "Gaining the benefits of a thin-client, browser-based solution cannot be accomplished by either Freightliner or Debis alone," says Wargo, "since Freightliner is responsible for converting the apps into thin client, and [Debis is] responsible for getting the infrastructure ready to support that environment. This is one reason why the gainsharing approach works. We are both incentivized to get our respective parts done because we both benefit from the cost savings."
ROAD BUMPS While Hassell is hesitant to discuss any specific stumbling blocks in gainsharing, he admits that it's not always easy. "We knew there were things that would be difficult," he says, "but we haven't had any showstoppers." He says that since Freightliner has a history of working with outside software developers, going outside for infrastructure wasn't a foreign concept. "We're also aware of outsourcing failures," Hassell says. "We are not a company that takes that lightly." He says it's when companies expect the partnership to steer itself that they run off the embankment. "The trouble that people get into is when they put up a plan and then walk away. If you want it to work, you can't turn your back on it."
Wargo acknowledges that the gainsharing approach is more complex than a fee-for-services arrangement. "For 4,500 workstations, itemizing [cost per seat] is a pain in the ass. But even though it's a bit more complicated, the gain is worth it," Wargo says. Also, there was friction when it came to redesigning the IT infrastructure. Drawing stark lines between their respective roles in this effort resulted in one or the other party having a dominant role, which made both bristle. "Sometimes," says Wargo, "where we drew the lines in the contract between what we do and what they do turned out not to be the best in operation, so there's been a give-and-take there. We sit down and work it out because paying lawyers doesn't benefit either of us."
Besides these minor detours, analysts predict other problems for the partners down the road. "I rest my case," says Gartner's Cohen, when she learned that the two are still in the honeymoon phase of their contract. "Check back with them in a year. Trust me, the bloom wears off the rose." Cohen says that in this type of gainsharing, the customer is literally giving away some amount of revenue to the vendor over time. "At first blush, when the first gains are realized, it seems wonderful," she says. "But, as time goes on, the buyer asks himself, 'Now why am I giving this revenue away? What have you done for me lately?'" The vendor might still be saving the buyer money, but that value goes unrecognized.
Alice Young, chief analyst for Dataquest's IT services group in Stamford, Conn., concurs. "The users forget what disarray, what lack of accomplishment in cost savings existed before the vendor came on the scene. Once they reach a new level, the users forget what it was like before they had access to the vendor's expertise."
Since there's little that can prevent this period of disillusionment from coming, Young advises vendors to be flexible to help the relationship survive.
"The buyer is going to expect more," she says, "so we need to see vendors proactively resetting the bar. The contract has to be such that the vendor can scout around for new value to deliver to its customer."
One of the biggest outsourcing vendors, IBM Corp., agrees that flexibility is crucial. Robert G. Farrell, vice president of global business development in IBM's Global Services division in Somers, New York, says the most successful gainsharing for IBM is the result, in part, of pliancy. "Since IT changes over time, being flexible and adapting to changes in needs and requirements--basically being ready to hit the reset button--is a necessity," he says.
The five-year length of Freightliner's contract could be another source of friction, Bendor-Samuel predicts. "If part of what Debis is doing is a onetime restructuring, Freightliner stands to risk overpaying as the years pass," he warns. Bendor-Samuel cautions his clients about signing the lengthy contracts--often five, seven or 10 years--that generally accompany these unions. Over time, the buyer comes to feel that it's paying too much or paying twice for the service. Another problem is that over longer stretches of time, the vendor's original advantage will be matched or surpassed by its competitors. By contrast, "short-term sharing" allows both sides to be clear about the role of the two parties, the economic conditions under which the contract was drafted, the type and amount of value generated, the time and money to be invested and the state of the competition.
But Hassell says he's anticipated that possibility already and has an evacuation route. "If three years into the contract we decide we've done all we're going to in savings--say we've achieved 75 percent of our overall goal and the rest is just not there--we can change the contract to a standard service agreement or terminate it."
If Hassell and Wargo's partnership does degrade over time, it will have plenty of company. Lepeak has seen gainsharing deals crash and burn many times. "In talking to clients," he says, "I've learned that 50 percent of the time, they are not happy even a year or so into the contract because they did not negotiate in their own best interest. They feel like they've been exploited by the vendor" or taken advantage of when a vendor gains an unexpected windfall at their expense. One of the most visible examples of this was the gainsharing relationship between EDS in Plano, Texas, and the city of Chicago several years ago in which EDS was contracted to improve the technology for collecting parking tickets. "EDS made something like 10 times what the city had expected," says Lepeak. "They were forced to renegotiate the contract because the city so clearly gave away the store."
CAUTION SIGNS Despite the odds, there are some ways companies like Freight-liner can help keep their gainsharing partnerships rolling along.
Lepeak says fundamentally, both sides need to clearly measure and define the goals they want to achieve. If each party lacks a clear notion of what the other considers value or gain, it slows up negotiations and can cause acrimony later.
Success also depends on how the relationship is managed. Michael Corbett, founder and president of Michael F. Corbett & Associates, a Hyde Park, New York-based outsourcing adviser, suggests creating a new governance system--a pool of executives drawn from both sides that will look after the gainsharing contract.
When considering a gainsharing arrangement, it pays to Shop around. "Get down to two or three companies and engage them in an intimate way," says Corbett. "Make sure you share the same values. And look for a track record of proven success." He says Freightliner didn't do enough shopping around. "If it were a standard fee-for-services contract, we would have bid it out," Hassell says. But since gainsharing is a more intimate relationship, Freightliner chose to stick close to home.
Don't rush in. The most successful gainsharing ventures analysts can point to are ones in which some type of relationship existed previously. Start out with traditional outsourcing to test the relationship. Then look at taking it to the next level, either outsourcing more critical processes or trying a creative pricing mechanism like gainsharing.
Be flexible but detailed. One of the paradoxes of gainsharing is that while a contract can't be carved in stone because of quickly changing factors, the contract must be specific enough to dispel confusion. Tim Barry, vice president of applications outsourcing at Boston-based vendor Keane, says specifics are a must. "Gainsharing is a great arrangement if you can get quantifiable," he says. "There have to be good, solid metrics in place."
Adds Bendor-Samuel, "I've seen a lot of these deals go bad because the contract was too vague. It's like when you agree to have dinner with your brother a year from now. What do you have in mind? A show and a nice dinner. What does he have in mind? Burger King. He's just thinking he has to feed you, not wine and dine you."
The Debis-Freightliner contract has the right mix of detail and flexibility, its authors contend. "In today's [climate of] economic growth, companies adjust day by day," says Wargo. "To me, that's the advantage of gainsharing--it means a constant adjustment. This contract is a living, breathing organism."
Hassell agrees: "In drafting the contract, we tried to be as practical as possible in terms of dollars and cents, but we also tried to build in some flexibility. There's a lot of language in the contract to help accommodate for things we couldn't initially anticipate." For example, if a PC is reduced in price, independent of Debis' actions, that savings would not be included in Debis' gainshare profit.
Another example of flexibility is the provision in the contract allowing for "events," such as Freightliner wanting to change network topology. "We said, 'OK, to do this there's going to be some cost,'" Hassell says. "We'll pay for it on a one-time basis only; there'll be no ongoing gainshare."
Trust, but don't be nave. Another gainsharing paradox is that, while most parties insist that trust is crucial to success, they also recognize the importance of transparency and self-interest. "Trust is not given; it's earned," says Bendor-Samuel. "In the meantime, be completely open in your dealings." In the Debis-Freightliner deal, both parties had an open view of the books, reducing the possibility of one or the other thinking they were being stung. "We have a very open relationship with Freightliner," says Wargo. "They have a right to audit us at any time; trust is a by-product of that."
While we may not know the ultimate outcome of the Debis-Freightliner partnership for several years, its success thus far seems greater than the merchant Kamaswami achieved in his gainsharing with Siddhartha. To the merchant's dismay, Siddhartha was so preoccupied by achieving spiritual enlightenment, it mattered little to him if he helped the merchant turn a profit or a loss. Corbett says the merchant learned an important lesson that can benefit everyone considering gainsharing--make sure that vendor and buyer interests are aligned before diving into such a partnership. "You don't want to find out too late that a vendor is more concerned with attaining nirvana than profit," he says.
Have you attained gainsharing nirvana or lost your way? Tell outsourcing expert and Senior Editor Tom Field your tale at firstname.lastname@example.org. Heather Baukney is a freelance writer based in Cambridge, Mass.
UNDER THE HOOD Who's partnering: Truck maker Freightliner and outsourcing vendor Debis The terms: Five-year contract valued at $70 million What's outsourced: Dealership client/server-based systems network and hardware (migrating to Internet-based architecture) The split: If Debis meets or exceeds the quarterly benchmark for savings on cost per seat, it keeps a percentage of the savings; Debis gets no other fees above its baseline costs.
RELATIONSHIP INSURANCE Converting a traditional contract to gainsharing proves a profitable investment "We're both on the same side of the fence now," says Mark Singleton, senior vice president of finance and operations for Fidelity and Guaranty Life Insurance, about his gainsharing deal with Computer Sciences Corp. of El Segundo, California.
The transition over the past four years from a traditional business process outsourcing contract to a value-based one has been a big improvement for Baltimore, Maryland-based F&G Life. "If you go back a year or two, when things were not managed as well as they are now, it was not as certain who was taking care of the details," says Singleton. "But things have stabilized in the last 18 months or so because of the improvement in the process [the shift to value-based pricing]. The walls came down immediately. We went from a defensive client-vendor situation to a real partnership."
Singleton credits the partnership as the driving force in his company's heady growth last year. F&G Life reported 1999 year-end new sales of more than $1 billion--a 100 percent increase over 1998.
The value-based pricing contract stipulates that CSC earns a fixed percentage of profit on top of its costs, guaranteeing that CSC will always earn a profit on the work it does for F&G Life, even if the work costs more than was originally expected. That's the upside for CSC, but it's also the downside.
Because the percentage in the contract is fixed, it is, in effect, a cap on the profit CSC can earn. If the profit margin on the vendor's services exceeds that fixed percentage, then CSC must refund the difference to F&G Life.
What then is CSC's motivation for efficiency? Singleton says the more efficient CSC is--for example, in processing new insurance applications--the more policies it will process overall and the more total profit it will make because profit is based on the number of units processed.
Singleton attributes much of the partnership's success to joint management staffing decisions. The partners launched a management integration plan in January that includes an F&G Life/CSC executive steering committee and joint strategic planning and operations and technology management teams. Functional CSC administrative managers report to F&G Life Vice President of Operations Steve Kennedy. The committees are charged to keep a close eye (with monthly, quarterly and some daily reviews) on the three areas in which CSC provides service--administrative services, product development and technology. Staffing and technology resource allocation and new investments are jointly discussed and decided on. Singleton says both sides are now more comfortable with the gainshare strategy in place, and most reviews of work are monthly and quarterly. F&G Life reviews IT system performance and CSC's costs each month and reserves the right to audit CSC's books at any time.