Financial Constraints on
Service and Outsourcing Projects

Introduction

Service and Outsourcing (SAO) projects are becoming increasingly more prevalent. And, unfortunately, the performances of the projects often do not meet the expectations of either the Client or the Contractor. The roots of the failure to meet expectations most often lies in the inability of SAO projects to adequately define and manage Scope. This inability leads to changes that increase costs and cause the financial constraints of either the Client or the Contractor to be exceeded. When financial constraints are exceeded, the relationship may be jeopardized and dysfunctional behavior may result.

So, what are the financial constraints and where do they come from? How do we know when they are exceeded or about to be exceeded? And, what makes SAO projects different from other projects?

Service Projects are not new. They occur in health services, building maintenance, information technology, payroll, administration, and countless other operational activities in which organizations engage. In recent years, competitive pressures have forced organizations to look more carefully at their operations and institute measures that improve their competitiveness. The focus of these measures is to distinguish between core competency and non-core competency operations and optimize the performance of both.

If a set of operational activities is not part of the organization's core competency and can be performed at a lower cost by an external organization, then there is opportunity for either a Service or Outsourcing project. Outsourcing is defined as a special case of a Service project where either Capital or Human assets are transferred from the Client to the Contractor.

The process of a Client organization's movement towards Service or Outsourcing and the resulting implementation by a Contractor appear to follow a pattern in which the successful outcome depends heavily upon the Contractor's Project Manager's ability to manage not only Scope and Cost but to manage Revenue and Profit. This is in contrast to the conventional view of Project Management methodologies where the treatment of Revenue Management and profitability is relatively untouched.

In the following we will:
•	look a little more deeply at the dynamic that leads to SAO projects,
•	examine Scope and Schedule implications of SAO projects,  
•	examine the meaning of Revenue to both Client and Contractor, and
•	examine the impact of Changes and the special pressure this puts on the Project Manager.

How do SAO Projects get started?

A primary driver for SAO projects is competitive pressure coupled with an Organization's belief that someone else can perform some of its operational activities at a lower cost. In order for the organization to take action on this belief, the activities should not be part of their core competency.  Activities, or operations, that are part of the core competency are generally closely held as they tend to represent that Organization's identity and uniqueness which provide their advantage in the market place. This means that outsiders are seriously considered for performing only non-core competency operations.

Core versus non-core competency operations varies from organization to organization, but examples of operations that tend towards SAO projects are:

•	Maintenance:	 	facilities and/or equipment
•	Administration:		payroll, billing, systems, networks 
•	Specialty skills:		training, technical writing, publication, mail room. 

As the Organization begins to look at its non-core competency operations, its primary focus is on cost. The Organization has quality standards and these must be met by any outside performer, but lower cost is usually the major reason for initiating a SAO project.

The Organization has probably "benchmarked " these operations and the first result of benchmarking is usually the recognition that the Organization can achieve lower costs internally by changing some of their procedures. These changes are implemented, costs are reduced, and the Organization moves the costs of these operations toward the minimum as shown in Exhibit 1.

At some point the Organization comes to believe that it has reached its lowest cost and can no longer achieve satisfactory cost reductions through internal changes. The benchmarking process has probably also shown that there are other companies specializing in the same or similar operational functions. Since these other companies do not compete in areas that are the core competency of the Organization, they are likely candidates for either a service or outsourcing project. The Organization may issue a Request for Information (RFI). What the Organization learns is that although the Companies (Contractors) may have somewhat different processes, they do have the ability to perform the required Operational Functions. The results of the benchmarking, validated by the results of the RFI, are depicted in Exhibit 2.

Service or Outsourcing?

If the cost advantage is sufficiently large, then the Organization will enter into a contract, usually with the least cost contractor—in this case Contractor A. At this time the Organization takes on the role of Client and the Client-Contractor relationship is established along with a new contractual entity. If assets are transferred from the Client to the Contractor because of this new relationship, then we have an Outsourcing Project; otherwise, it is a Service Project. The Project Management implications of Outsourcing versus Service derive mostly from the need to deal with the complexity of asset transfer, especially if these are human assets. Transfer of physical assets presents a level of complexity because of the financial and legal activity required for transfer of ownership of the assets. But, transfer of personnel requires the additional activity associated with labor laws and the involvement of the Human Relations Organization to assist personnel in adjusting to a new Company. This makes the project significantly more complicated for the Project Manager and places greater emphasis on Communications and related planning. 

Even though there may be a significant difference in the complexity between Service and Outsourcing projects because of a transfer of assets, they are otherwise quite similar in the tools and methodology required for effective project management,

•	methods of defining scope and scope control are similar
•	the characteristic resource expenditure curves (Exhibit 6) have the same configuration 
•	Revenue Management, as well as Cost Management, is critical.

Statement of Work and Change Management

In either a Service or an Outsourcing project, the work is in support of operational processes. This means that the Statement of Work (SOW) needs to describe work activity within the context of the processes. The processes rarely stand alone, so the SOW needs to define the interfaces to the processes and be very clear about the roles and responsibilities of both the Contractor and the Client. The SOW is based upon internal processes that are rooted in the culture of the Client. These processes are rarely well understood nor well documented so that it would be very naïve to expect the initial SOW to comprehensively define all of the work to be accomplished for the life of the project. The Project Manager should expect that the Scope will change as the Project proceeds, and Change Management will be a central theme of the Project.

Change Management needs to start the first day of the Project. It is usually a good practice to issue a Change Order Zero right after the contract is awarded. The purpose of Change Order Zero is to reconcile any changes that were introduced to the proposed SOW as a result of contract negotiations. The value of Change Order Zero may be zero indicating that the contract negotiations had no impact on the proposed pricing. Most often, there is some alteration to the proposed scope of the project as a result of contract negotiation. Capturing this in the beginning preserves the integrity of the project and begins the discipline of Change Management. 

Effect of Change

The impact of changes needs to be well communicated to the management of both the Client and the Contractor because the general trend of change is toward increasing cost. (Cost for the Client, Revenue for the Contractor). A major driver of change on SAO projects comes from the lack of a comprehensive scope definition and the requirements of the interfacing processes. The Contractor will normally implement processes with a different look and feel that may not address the interfaces very well. A different look and feel is almost always resisted initially. The tendency of the Client Organization is to pressure the Contractor to change the look and feel back to the old way and support the interfaces in the manner to which they are accustomed. Sometimes this can be done with an overall net benefit. Often, however, it simply leads to migration back to the original processes at a higher cost than before the Project was initiated. The net effect of the changes is to increase project costs, Exhibit 3.

 Again, the key is Communications. The Project Manager must clearly explain the impact of the requested change to the Client. The Contractor and the Client need to work together to understand that the change is really required and to arrive at a net cost that considers both sides—the Project itself and the rest of the organization that interfaces with the Project. Even if Projects cost goes up, as long as the net cost is contained or improved, the Change may be implemented. If, however, the Client and the Contractor jointly determine that the Change Request is basically a result of resistance to the new processes brought on by the Project and does not provide a significantly favorable overall cost impact, then the Change Request should be rejected.

The issue of Change Management and its effect on Cost Management is a familiar theme of Project Management. It is of particular significance in SAO projects because of their long period of performance. This can allow seemingly small incremental costs to accumulate in time to become large amounts. It may seem beneficial for the Contractor to have these small incremental costs accumulate to large amounts because this is the Contractor's Revenue and signifies a trend of Revenue Growth.  However, this trend is contrary to the intent of the Client to maintain or reduce cost. So, while the Client is trying to manage for cost reduction, the Contractor may seem to be managing for increased revenue and this is the basis of a fundamental conflict because they are managing the same dollars.

As Changes occur, the Contractor will endeavor to price the changes to preserve his profit margin and maintain a constant percentage difference between cost and revenue as shown in Exhibit 4. As the changes accumulate, they may exceed the Client's original cost for performing the operations. This  scenario is described in Exhibit 4. As the Contractor's revenue approaches the Client's Original Cost minimum, the Client begins to question the value of the contract. So, the cost of the operations prior to award of the SAO project is one major Financial constraint of the Project—call this the Cost Constraint. The Contractor most often will not know the value of this constraint. The tendency is for Client Organizations to maintain this information in confidentiality throughout the bidding and performance phases of the project. 

Alternatively, as changes occur, if the contractor does not act to maintain his profit margins then the revenue curve begins to flatten while the cost continue to rise as shown in Exhibit 5. The Client may be happy in that Changes are occurring at a reasonable cost, but the Contractor sees this as declining or less profitable revenue and becomes very concerned. 

The Contractor has very stringent requirements to maintain profitability (it can be a condition of employment for the Project Manager). Shrinkage of the percentage difference between revenue and cost (margin) represents decreasing profitability. If left unchecked, the loss in profitability can affect the viability of the Contractor. The Contractor’s margin (profitability) is the other major Financial constraint of the SAO Project—call this the Profit Constraint. Just as Client Organizations are reluctant to disclose their cost criteria, Contractors are reluctant to disclose their profit margins. 

The Contractor's Project Manager may know the Profit Constraint but may not know the Client Cost Constraint. The Client may not know the Contractor's Profit Constraint. This is not conducive to good communications and a successful project; both Client and Contractor should know or at least have an understanding of all the constraints.
 
How does the Project Manager identify the Financial Constraints?

The Client's original cost of the operations (the Cost Constraint) is usually well known to the Client. It is one of the metrics in the benchmark activity and it was very likely a factor in the justification of the project. The Project Manager is advised to ask the Client for this Cost value at the onset of the project. This is a figure upon which both the Client and the Contractor can agree should not be exceeded. If the Client doesn't provide this information the Project Manager is advised to estimate this Cost Constraint based on a reasonable uplift of his own costs and establish it as a visible constraint for the project team.

The Profit Constraint is identified in a Profit and Loss (P&L) statement of the project. It is normally developed with the proposal and a satisfactory margin requirement is incorporated in the proposed pricing. A good practice for a SAO Project Manager is to take the P&L that is produced with the proposal and update it periodically over the life of the project. This provides the view of profitability that is most easily communicated to the Contractor's project team and management. Along with maintaining a P&L statement, the SAO Project Manager should maintain a balance sheet to assist in managing cash flow.

There is not a great need to dwell on the nature of the P&L and Balance Sheet. These are standard instruments of every business enterprise. They come into play in SAO projects because these projects deal with the transition of business operational activity in the beginning of the project and financial performance is a key ingredient of successful operations. As the SAO project matures, it become an operational business in its own right. A finance person undoubtedly participated in the development of the proposal to assure that the proposal/bid met the company's profit objectives. The SAO Project Manager should retain this resource as part of the SAO Project Team to monitor both Cost and Revenue and update the financial instruments. 

For the SAO Project Manager, managing Revenue and Margin in addition to Cost is a natural extension. Planned, Estimated and Actual Revenue are easily added to the traditional Cost vs. Time view of the project as shown in Exhibit 6.

In this view, the Project Manager begins the project with a planned Revenue and Cost. This is a forecast of Revenue and Cost for the contract period. These are fixed with the proposal and should only be changed by approved Change Orders. The difference between Revenue and Cost is an indication of Margin. This view also indicates when the required Margin objectives should be met and when "break-even" should occur. Actual Revenue and Cost are plotted in the same view so that deviations from plan and the effect on margin are readily apparent. The long duration of SAO Projects renders the normal project metrics at completion (ETC, EAC, BAC) almost useless because completion may be too distant. Completion of a SAO Project is tied to the term of the contract and may be extended by successive renewals. Most important on a SAO Project is meeting the Service Level Agreements and staying on the Financial Plan. Deviations from the Cost or Revenue Plans should be handled as a “Closure to Plan” activity. This is also shown in Exhibit 6.

The slope of the Revenue during the Managing phase in the Exhibit 6 view indicates the Cost Constraint. This constraint will typically be exceeded during the Implementation Phase. The project plan should allow for this and let constraint become firm in the Managing Phase. The Profit Constraint, likewise, applies during the Managing Phase. Most SAO projects are Fixed Price—usually meaning that the Contractor can expect negative margin throughout the Implementation Phase. If this represents a severe hardship to the Contractor, then appropriate early payments should be negotiated prior to award.

Even though the SAO Project Manager can identify and manage the Project Financials, the issue of conflicting objectives between the Client and Contractor about Cost/Revenue remains.

The Financial Conflict on a SAO Project 

The fundamental conflict on a SAO Project (all projects really) is that while the Client tries to maintain or decrease costs, the Contractor tries to maintain or increase his revenue; and Client Cost and Contractor Revenue are the same thing. A healthy SAO project will deal with this conflict in straightforward problem-solving manner. Generally, revenue growth due to adding scope to the contract is acceptable while price increases for in-scope activity are subject to serious scrutiny.  A portion of reduction in Contractor cost should be passed on to the Client to aid in the competitiveness of the enterprise. The Project Manager has the primary responsibility for resolving this conflict and needs to know and not exceed the limits for revenue growth; and he also needs to satisfy the Contractor Management's need for profitability. Revenue growth that exceeds the Client's Cost Constraint may lead to dissolution of the contract while not meeting the Contractor's Profit requirements can lead to unsatisfactory Contractor performance or even withdrawal from the project. These are the Financial Constraints of the project and the Project Manager wants to stay within them. No one wins if either of the constraints is exceeded.

Recommendations for the SAO Project Manager

•	Ensure that the SOW comprehensively describes the processes and their interfaces that are the project targets.
•	At the beginning of the project, define the Cost and Profit Constraints, perhaps in a Letter of Understanding.
•	Begin Change Management at the start of the project with Change Order Zero to capture results of contract negotiations.
•	Develop and maintain both a Profit and Loss statement and Balance Sheet as part of the Project Management deliverables.
•	Track actual Revenue and Cost against planned Revenue and Cost.