Analyst Insight: Many companies struggle with how to properly create and operate sound governance mechanisms in complex outsourcing relationships. This article explores key themes to better understand “good governance.”

Governance in outsourcing relationships is critical, because the service provider becomes an extension of the company outsourcing. Great governance means shifting the mindset from simply managing the supplier to governing an extended part of your enterprise. 

Unfortunately, many companies struggle, and multiple studies have indicated poor governance results.

Following are the five key themes for “good governance”: 

Governance isn’t free – but poor governance is costly. Governing an outsourcing relationship is not free; at a minimum, organizations must devote the right resources to achieve service excellence and general compliance.

However, good governance is far more than compliance. It serves to create a healthy relationship that can quickly make decisions and resolve issues. Equally importantly, it drives more proactive collaboration efforts aimed at achieving continuous improvement and transformation initiatives.

Research by Cullen, Seddon & Willcocks suggests that the cost of governing an outsourcing relationship ranges between 3% and 8% of a contract’s value – with an average of 4.2%.

Some companies think, “My gosh, we can’t afford that kind of overhead!” Instead, think about the cost and impact of not investing properly in governance.

Now,  companies and industry organizations are beginning to understand the need to design and institutionalize sound governance practices as a critical component of outsourcing relationships.

There’s no clear definition of governance. If governance is essential, why haven’t organizations perfected the art, science and practice of great governance? One reason is a lack of clear understanding of what good governance is. In fact, there is not a clear, agreed definition of governance! 

Think about designing a “best-fit” governance framework and mechanisms using the University of Tennessee's “Unpacking Outsourcing Governance” whitepaper.

Five elements of good governance. Good governance should include both contractual and relational governance mechanisms. University of Tennessee research has identified four key governance elements, or themes, that should be formally embedded into outsourcing agreements.

• Relationship management. How an organization structures and supports its interactions with suppliers.
• Transformation management. Good governance practice includes having formal processes for managing contractual changes. However, it also includes how the parties will collaborate on continuous improvement efforts, or even work together on larger transformation initiatives or new product or process development.
• Exit management. These mechanisms are essential for governing an outsourcing agreement because they ensure the parties have outlined how they will manage either a full or partial termination of the agreement.
• Compliance (special concerns and external requirements). The final element addresses compliance, and incorporates specific market, local, regional, national or even company-specific compliance requirements. 

“Best fit” versus  “best practices.” APQC regularly conducts benchmarking across Fortune 500 organizations. One study found organizations are applying governance through a far too narrow lens of simple supplier relationship management programs. Among organizations with SRM approaches in place, 80% rely on them to reduce risk; 72% to monitor contract compliance and service levels; and only 38% are thinking more comprehensively about using governance mechanisms to drive innovation and transformation efforts.

Understanding the purpose of the business relationship along the continuum from purely transactional relationships to investment-worthy equity partnerships helps to determine the appropriate scope of work, performance management approach, pricing approach and governance structure. As such, APQC argues that organizations need to evolve from best practice SRM programs to thinking in terms of best-fit governance mechanisms. 

All complex contracts are incomplete. If contracting parties could specify their respective rights and duties for every possible future state of their relationships, their contract might be called a “complete” contract. The contract would have no errors, omissions or ambiguities.

While some argue it is impossible to write a complete contract, one point is clear: The more complex the contract, the harder it is to draft a complete contract. It is myopic and inefficient to try to get to a complete contract in a highly complex environment. Better to see governance as the framework within which the integrity of a transaction is decided. Instead of trying to write a complete contract, the parties should put in place governance mechanisms designed to help keep them in continual alignment, post contract signing, in addition to managing any shifts in the business environment. 

Ideally, contracts are structured with flexibility so that potential maladaptations are eased or avoided through mechanisms that cope with unexpected disturbances as they arise.

Creating a flexible contract framework — coupled with sound governance mechanisms that can cope with unexpected disturbances as they arise — can help organizations address the dynamic nature of business.