The hidden cost of auctions

The hidden cost of auctions

Outsourcing is a recent industry and the role of advisers has changed dramatically since the 1990’s. Having spent almost twenty years as a banker and then over ten years helping sell outsourcing I am struck by the parallels between banking and outsourcing.

I believe that outsourcing executives and clients can become smarter by learning from successes and mistakes gleaned from the banking industry. For this first piece our focus will be on the hidden cost of advisers running auctions to yield “low cost” to satisfy management.

In the early 1990’s one of my best friends lost his job as the CFO of a large, top-brand, European sports equipment company. What had happened is that the firm had expanded into new activities in North America and had expected a reasonable volume of business but was careful to reduce foreign exchange. The CFO entered into a series of forward exchange contracts to sell forward the expected revenue in order not to speculate on currency.

What happened is that through the conjunction of economic slowdown and very abnormal weather conditions the season turned out to be terrible across all sports. Sales targets were not met and large operating losses were incurred. But the worse was that the company was still forced to honour its foreign exchange commitments and had to buy dollars (it did not have) in the open market at a high cost with local currency (it had to borrow) and this compounded the loss. The company nearly collapsed and the CFO had to go.

In the last year we have seen many replicas in outsourcing. From the beginning of the twenty first century, companies had increasingly brought in well-known third party advisers (TPAs) to run what we would call auctions and managed to extract perceived great value from reliable vendors. Vendors do not like auctions but they thought that such TPAs helped in qualifying and structuring deals and even mega-deals. Business was good for all!

Then comes 2008 and the economic circumstances change abruptly. Some benefit and volumes rise a lot (to the related benefit of vendors who need to ramp up volumes) but in most cases volumes plummet and in some cases and for some periods disappear almost entirely. Many attractive cost cutting and low price deals turn into “take or pay” contracts and penalize the locked-in clients (far more than vendors!).

In the same way my CFO friend could have used FX options rather than FX forwards, TPAs should have developed detailed models and strategies to ensure that trade-offs between cost, flexibility (up and down but also from innovation) would be understood, negotiated and incorporated in contracts and governance. In cases when a company has to cut cost to the bone or die a pure auction is probably acceptable but in most cases companies sourced rather than outsourced and pay a price later.

My personal lesson is that in auctions the auctioneer often is the only sure winner and that outsourcing must be stress tested under the watchful eyes of senior management and boards.

Rule #1: There is a price to pay for locking in too low a price…

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