Structural changes in workforce composition and how we work have dominated the headlines since the COVID pandemic and received much research attention.
Most of the analysis has focused on remote working, the gig economy, hybrid models, and the astounding growth of the contingent workforce which today is over 50% larger than pre-pandemic and represents about 36% of total US employment.
What has received less attention are high-end professionals working in teams, often intermediated by giant corporations like Accenture, TCS, Deloitte, and the like, delivering specific projects for their clients. The delivery of these multi-million dollar projects for ERP implementations, engineering, legal, research, etc. is governed by “Statements of Work” (SOWs) that lay out what the service provider is supposed to do, how they are being compensated and what to do if things go wrong.
Ronald Coase in his 1937 Nobel Prize winning paper explained that firms exist because of the differential transaction costs of organizing work inside firms based on trust versus arms-length ad-hoc contracting by individual workers. Applying this insight to the IT consulting giants makes intuitive sense, as even the most gifted developers would find it hard to develop the high-value clients that these corporations serve and gain the reputation of delivering high-profile projects consistently.
But what differentiates these SOW firms from ordinary staffing agencies?
We argue that SOW labor occupies a unique market space where buyers purchase neither an identifiable individual person nor a tangible and fungible product available in a competitive market. Therefore the labor intermediary implicitly provides productivity-enhancing technology, otherwise, the buyer would just hire their own team.
We estimate corporate SOW spending at around half a trillion dollars annually worldwide with half occurring in the US. Despite the meteoric growth in this sector and the critical importance of project success to the clients, techniques applied by buyers to source and manage SOW contracts are simplistic, risky, and generally ineffective.
Current State of the Art
SOW labor occupies a unique market space where buyers purchase sophisticated custom services from an intermediary who manages a team of skilled individuals to deliver a project objective.
This makes it hard for buyers to manage such expenses. Micromanagement approaches that track resources, hours, pay rates, and mark-ups are common but misguided as they were developed for individual, client-managed resources and ignore the productivity gains that are supposed to come from vendor-managed teams and their respective technologies. Frustrated with the tediousness and ineffectiveness of this approach, buyers often have a knee-jerk reaction and switch to the other extreme: flat project pricing, competitively bid at the outset.
We will argue that neither approach is right. Micromanagement results in higher costs and longer projects because it does not incentivize vendors to be productive. Flat project pricing, on the other hand, is too risky in practice, as provider switching mid-stream is impossible or extremely expensive. Instead, buyers should invest more resources in the initial strategic sourcing process and structure of lasting vendor relationships with competitive economics and viable risk mitigation options.
Characteristics of Effective SOWs
Complex projects designed to create custom products by coordinating multiple parties are not fundamentally novel, but unlike building construction, for example, IT, engineering, management consulting, and creative services do not have mature sourcing and management systems. SOWs have unique characteristics that make them hard to source and manage:
Because buyers have maximum leverage when negotiating with vendors, they need to drive toward effective SOWs with these characteristics:
Transparency. The SOW should contain clearly defined economic terms that are directly attributable to the economic value-add of the service being provided.
Competitiveness. A competitive SOW should be in line with best-in-class metrics for per diems, hours consumed, job specifications, and most importantly outcomes.
Longevity. Changes in market conditions are common and well-designed SOWs should be able to handle that while preserving the relative competitiveness of the contract.
Incentive Alignment. The highest productivity leverage comes from aligning the interests of vendors and buyers and incentivizing maximum project ROI. Most of the SOW design effort should be focused here.
Compliance. The SOW should measure and enforce non-price terms related to quality, deadlines, security, DEI, industry regulations, SLAs, and key operational performance metrics.
Structuring Effective SOWs
Pricing methodology is the key design choice because pricing determines incentives and drives behavior. SOWs are complex and potentially risky, so multiple simultaneous pricing methods must be applied to the different SOW components.
While there is no single perfect SOW design, we believe that sophisticated buyers should consider the following approaches.
Dynamic Budgeting. Despite one’s best effort to create a detailed pricing schema, there will always be an error term that is not captured. We suggest that this is handled via smart budgeting whereby the parties agree to dynamic “not to exceed” amounts including pre-priced change order tasks for common specification changes.
Task Pricing. Being able to break down the project into identifiable tasks for which the buyer pays the vendor is obviously the gold standard and its usage should be maximized. Tasks should stand independently, i.e. have transferable value with minimal switching costs. Well-defined tasks should be transferable to a new vendor if the need arises.
Portfolio Pricing. Portfolio pricing is a variance management technique for tasks that exhibit random deviation. Therefore, it requires a large number of tasks that are similar in their a priori known characteristics, careful portfolio construction, and rules for managing extreme outcomes to protect vendors. A classic example is fixed pricing for legal insurance defense cases.
Milestone Pricing. While similar to Task Pricing, this approach is less desirable, because milestones are arbitrary measures of progress. There is a difference between five tasks being completed and ten tasks being half done. We recommend this technique only when task pricing fails and when milestones can be objectively measured.
Key Talent Provisions. In situations where the vendor choice is highly influenced by the vendor providing impressive talent, one has to make sure these people actually work on the project. It may be worthwhile to agree to very high per diems for “superstars” and ensure they spend a defined minimum amount of time on the project.
Cost-Plus. Finally, when all else fails, buyers should try to re-engineer their vendor’s cost structure to make sure there is no excess. While common, we find this approach fundamentally flawed as it ignores productivity differences, innovation, and technology. It should be reserved for hard-to-anticipate or hard-to-specify services and represent less than 20% of the value of the project.
Performance Linked Compensation. Overall project performance risks and rewards should be shared between the buyer and vendor for activities that are within their respective control. Typically this is handled via milestones that trigger appropriate contract penalties or rewards. The specific structuring of such performance compensation clauses is critical and requires careful design.
Strategic Sourcing and Management of SOW Spend
Strategically sourcing SOW projects requires that the buyer is willing to establish a strategic relationship with a set of preferred vendors for a significant portion of current and future projects. Sourcing only when an immediate need has arisen is suboptimal and smart buyers aggregate multi-year demand with a smaller set of suppliers, increasing the “value at play” by orders of magnitude. Here are the key steps:
Prototyping. It is hard to predict what future projects might look like, but any buyer has close to perfect information about what happened in the past. Going back a few years and documenting in detail how prototypical projects have been executed can serve as the structural foundation for baseline and RFP evaluation.
RFP and Negotiation. The purpose here is to maximize competition, make bids comparable, reduce or eliminate any vendor risk premium that may arise out of unclear specifications or inappropriate risk transfer, and most importantly, incentivize the vendors to maximize project ROIs. Buyers should bid out each prototype at several levels of abstraction (i.e. overall, milestones, cost-plus) and then conduct a “synthetic minima” analysis on the bid received to understand the economics of different bidders in great detail to inform effective negotiations.
Ongoing Management. Even the best SOWs can fail miserably in execution. Important projects can take years with eventual costs not bearing any resemblance to initial projections. We will not repeat the rich body of project management advice here, but note that following our advice on SOW design will make ongoing management far easier.
Nevertheless, it is important to choose a procurement and resource management system that can accommodate the complex pricing approaches discussed above.
Many legacy staffing systems are architected around the concept of managing individuals with job descriptions, skills, hourly rates and hours worked. We dismissed this micromanagement approach earlier in the article. More generic procurement systems are architected around catalogs of items – think office supplies. Complex SOW projects are nothing like office supplies because there is no tangible, fungible, and competitively priced output, making such systems a poor choice.
Sophisticated alternatives exist and their architectures are flexible enough to accommodate the simultaneous, multi-level hybrid pricing methods discussed here. Given the enormous costs and risks inherent in large-scale SOW projects, corporations are well advised to invest in such systems.
The impact of strategically sourcing SOWs and implementing their ongoing execution in a sophisticated system results in dramatic cost savings of around 35% and an equally dramatic reduction of typical project execution time and significantly improved risk profiles. Given the strategic importance of SOW projects for corporations, more resources must be invested in structuring and managing these relationships.
By: The Mitchell Madison Group
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