Outsourcing — A RUNAWAY TRAIN

Internal Auditor, June, 2000 by Jonathan Figg

Internal auditing can safeguard the organization and minimize the hidden or unexpected costs of outsourcing by ensuring that proper contract development and administration practices are in place. Marcella points out that outsourcing providers tailor the contracts to their benefit in all areas, but internal auditors can step in as an extra line of defense to make sure that the final contract protects the organization's best interests.

According to Morgan, a key role of the internal audit function should be to determine whether or not contract terms and conditions are clear. "If the terms are gray, then exhibits will be needed to explain the murky areas," he says. "Internal auditors can identify ambiguities in the contract that could present future problems."

More specifically, internal auditing can push for key clauses to be incorporated into the outsourcing contracts. Experts recommend adding clauses that detail penalties and incentives based on the firm's performance; outline payment and invoicing procedures; grant internal auditors the right to audit the firm; allow the company to access or regain important records on the outsourced process; and terminate the contract if predetermined conditions are violated.

Developing effective penalties and incentives for the outsourced function is an essential element of the contract. Morgan recommends recalculating incentive clauses to ensure that the organization is not "giving away the farm." He adds that if service quality goes out the window, the contract's penalty clause might earn the organization some recompense.

Goepfert's audit team pays dose attention to invoicing and payment procedures in outsourcing contracts. "If the organization is paying a labor rate to the vendor, someone needs to make sure that the rates are listed in the contract," advises Goepfert. "Internal auditors need access to payroll registers to make sure that the contractor is not billing the organization for gross misstatements of the numbers." He also recommends establishing clear time frames within the contract, outlining when the vendor will be paid.

One area of the outsourcing contract that is of particular relevance to internal auditors falls within the audit clause. Without a right-to-audit clause, the organization essentially has to trust the firm's claims about its controls, environment, and abilities. Morgan defines an effective audit clause as one that allows the auditor access to key records of the outsourcing provider so that reviews of its service can be performed. Moyer ensures that the right to audit is incorporated into every outsourcing contract signed by her organization. "In the contract's language, we'll reserve the right to have a public accounting firm or our own internal audit function conduct the audit; but National Geographic gets to make that call--not the vendor," she says. Moyer's audit clause asks for a reasonable amount of staff time at the outsourcing firm's site, free of charge, for her team to conduct audits. Moyer has also added language to the contract stating that if the provider pays for a third-party audit report, her o rganization will receive a complimentary copy. Goepfert takes a similar approach and reiterates the need to get it in writing: "Unless the terms are specified up front, an outsourcing provider might charge your organization for a report that you believed would be provided as part of the contract agreement."