This essay is part of a series on evaluating the designs of services, taking the case of a healthcare system outsourcing its laundry operations. The first part introduced the organisations and the decision to outsource. This second and concluding part, discusses the selection decision, how the contract performs, and what happens a few years later.

Gut feel with numbers
The outsourcing decision was down to X and Y, both offers being well above the 1000 HEX threshold in terms of net value. Should UHG go with Y for having the highest score? Or X, with a lower price tag? The answer lies in the E ratings and the associated non-financial considerations. Outcomes are what you pay for. Experience is what you pay with. This is where belief and confidence matter. Essentially, Y is asking for a higher price but promising that the hospital staff will have a much better experience when using the service. X is betting that the users will be happy if the quality is even slightly better than what they are presently used to, with WMC. During internal discussions, which included key figures from UHG, the procurement team weighs in with a recommendation in favour of X, for the following reasons.

X offers a net value that is significantly higher than the threshold criterion of 1000 HEX. They do so by matching the O and P values of WMC, while improving upon the quality of experience for the hospital staff. Of course, Y promises an even higher net value because of a more advanced technology, a larger capacity (almost twice that of X), and data analytics providing deep insights into operations. However, the UHG couldn't see how those things would make big O difference. They were eyeing the E numbers instead and thinking that, if X can be motivated to improve E number by a few basis points, the net value their services produce will approximate that of Y. Therefore, they decide to award X an initial 3-year contract with the following stipulation.

Every six months, QUO would conduct evaluations to ensure that N of X doesn't fall below 1400. That would give X some time to set up and adjust to the demand patterns of the growing UHG system, while also protecting the interests of hospital staff. If X were to achieve N=2000, they would receive a bonus payment of 500 HEX per month, for that period. The decision was partly influenced by an effort to improve the quality of experiences of UHG staff from all support services. By specifying a +/- range for N, instead of insisting on a point target, UHG believed they would promote a healthy tension and encourage X to truly understand the needs of staff and patients.

Same factors, different costs.
All three providers were eager to win the contract, given the reputation UHG has for developing long-term relationships and treating suppliers like partners. Each firm came with its own expectations of O, P and E in return for promising the same. And, while being in the same business means they're subject to the same industry-specific factors, each provider has different customer bases. Z is a company that found success as a low-fare laundry offering a no-frills service. Its customers are mostly small businesses who are price-sensitive and don't mind a few conveniences, including paying in advance and putting in more effort through self-service. In contrast, Y caters to the higher end of the market, serving customers with large-scale operations and exacting standards, but also deeper pockets. Therefore, Y has designed its operations to deliver higher net values at higher prices. They're always out front with new technologies, process innovation, and user experience – e.g., being the first to offer hospitals, exchange delivery carts.

X thrives in the middle of the market. They started as a small operation but then quickly grew after making major investments to fulfil the commitments of their first large contract, from a customer almost as big as UHG. There were growing pains but they managed the transition. They’ve learned from past mistakes of aggressive cost-cutting, the predictable consequences of which were operational failures and customer dissatisfaction. They embarked upon a careful study of how to better implement the division of labor between users and agents, keeping in mind the peculiarities of serving large enterprises. The E-rating of UHG matched that of their customer base. That's why they felt confident about winning the business and doing a good job.

Therefore, X, Y, and Z, each saw a different level of difficulty in servicing the UHG system, even though QUO had given the customer an independent and objective E-rating of 0.90. Each firm adjusted that number to reflect its own reality across a customer base. Indeed, providers must optimise their designs to work well for all their customers, even if some contracts require special considerations and force a few changes in design. But what may be special for one customer, could be costly for others, and providers cannot achieve a target level of operational efficiency if they end up running a separate business for each contract.

So, with the risk-adjusted E-rating, what did the expected values look like?

N for X,
O = 10000, P = 8750, E = 0.92
N = 10000 - 8750/0.92
N = 489 HEX

N for Y,
O = 11500, P = 10500, E = 0.98
N = 11500 - 10500/0.98
N = 785 HEX

N for Z,
O = 9000, P = 8000, E = 0.96
N = 9000 - 8000/0.96
N = 667 HEX

Pragmatism pays off
As we can see, UHG gave the contract to the provider with the lowest expected net value. But why should it matter as long as UHG gets the net value X has promised, right? Indeed, in the first two years, X surpassed the UHG net value targets and profited from the contract. UHG therefore decided to extend the contract by another three years at a higher price of 10250 HEX. Meanwhile, X won other contracts based on their UHG success story. They also expanded into the hospitality industry after winning a contract with a major hotel. There are differences between hotel beds and hospital beds, but the economies of scope are sufficiently large. There were economies of scale as well. From UHG alone, which continued to experience significant growth, larger and larger loads arrived.

The CFO at X was pleased, looking at the net value. Here's what she saw.

At the start of the 4th year
O = 10750 ... including the bonus of 500 from UHG
P = 9000 ... higher energy costs and greener operations
E = 0.92 ... UHG users as experienced by X
N = 967

From the CFO’s perspective, the additional investments they made toward improving the UHG user experience from E = 0.95 to 1.05, were paying off in the form of the bonus payment. Otherwise, the net value would've been much lower. The bonus was well deserved. With X providing a higher quality of experience, the higher net value UHG was enjoying, at N = 2000, subsidising the bonus. QUO received a bonus of its own, for helping UHG successfully outsource the laundry operation. UHG felt vindicated in their belief that a business ecosystem will be stronger if suppliers have healthy margins. While prices remain fixed, costs still vary. Operating margins should be large enough to absorb unexpected costs. UHG wants its suppliers to be an integral part of its operations, indistinguishable from internal units such as WMC. Also, being ardent pragmatists, UHG leaders invest in relationships because, the goodwill and trust that accumulates over time, reduces transaction costs.

New realities set in
In the sixth year, things started to noticeably change. For the first time, the N missed the net value bonus target, even though they didn’t fall below the lower threshold of 1400 HEX. The expanded user base led to situations in which some users were very happy and others not so much. Soiled linen was piling up in new patterns. To cope with the added demand, X decided to hire a subcontractor to handle the pick-up and delivery of linen. That didn’t help much. The costs of making their business more sustainable, were also increasing. Meanwhile, two hospitals acquired by UHG brought into the scope new care settings. That had an effect in the overall quality of demand X had to now deal with.

By the middle of the 6th year:
O = 10750 ... barely made the bonus target
P = 9050 ... subcontractor and sustainability costs
E = 0.91 ... UHG becoming more difficult to serve
N = 805 ... lower than before, but still not bad

By the middle of the 7th year, things became a bit difficult for X as they tried hard to keep the net value for UHG at 1500 or above. UHG staff could feel a noticeable difference as the quality of their experience fell to 0.95. The Qualtrics data confirmed that. At the same, the delivery and support staff at X, both those at the laundry facility backstage, and those in the front stage at the hospital, were feeling a lot more stress than before. Their personal bonuses were tied to the E-rating they received from QUO each quarter. Sustainability compliance became costlier.

By the middle of the 7th year:
O = 10250 ... missed the target; no bonus
P = 9000 ... operations already lean; sustainability
E = 0.90 ... getting adjusted to the expanded user base
N = 250 ... much lower net value

What happened?
X seems to have fallen into a vicious cycle triggered ironically by their own success and that of their customer. Their success in the first two years made them gladly accept the contract renewal, even though the UHG operating environment and user population was steadily changing. While they strived to maintain their quality of supply, the quality of demand was changing. Their other wins, including the ones with hotels, were stretching their operations thin. They could cut costs only to the extent that there was waste. But if the operations are already quite lean, further cost-cutting leads to faultier operations, affecting the quality of outcomes and experiences for customers. In response to lower net values, customers could either pay less, use less, or simply take their demand elsewhere. That would leave providers worse off than before. While UHG did not do that, X had to keep its promises by absorbing the additional costs.

The quality of demand from the UHG system during the later years, was simply costlier to serve. The costs of more sustainably processing the linen, including the costs of energy, materials, waste, biohazard, and transportation, continued to steadily increase. Given the nature of fixed price contracts, X could not charge UHG extra to recover the additional costs. Normally, an increase in the volume of demand is greeted well because it brings down unit costs. But there are also diseconomies of scale. While the UHG contract had bonus payments for X tied the net value targets, it didn’t account for the fact that a more expansive demand can also be more expensive. The recent troubles of Starbucks are an illustrative example.

Conclusion
It is important to state that the laundry outsourcing contract did not fail. It just fell short of expectations despite best efforts. Many contracts are like that. What the UHG/X case demonstrates is the complex dynamics of long-term commercial agreements in steadily evolving business environments. Customers can go to market with the best of intentions, offering suitable incentives for their suppliers. But the changing nature of demand, coupled with external factors like sustainability requirements and business expansion, can significantly impact service delivery and profitability over time. The case also underscores the importance of bi-directional risk adjustment, based on mutual understanding, cooperation and trust, if indeed there is a genuine desire for partnership.

The net value equation is but just one tool to get an intuitive feel for quality of experience as a cost factor. In the numerical examples you have seen, the E-rating has an oversized impact on net values. The E-rating coefficient in this simple tool is there to adjust the impact. In reality, easily accountable things, such as price and budget, weight into decisions much more than factors such as ease and effort that are difficult to quantify and measure. But that doesn't mean they don't matter. Just because something cannot be plugged into a financial model, doesn't mean it won't accumulate and cause problems. Take for example the growing challenge of making services more sustainable. That's the E-rating troubling customers and service providers. In fact, you can modify the net value equation, by redefining the E number to be the ratio of positive impact and negative impact, in place of ease and effort. It will work just the same.