UK: Maintaining Value in Outsourcing Deals

Last Updated: 28 July 2004
Article by David Strang

Entering into a long-term outsource deal inevitably requires a great deal of commitment on the part of both supplier and client.

Introduction

A mistake in the due diligence process by the supplier could lock it into a loss making project which will literally bleed cash for a number of years, whilst the client will worry about the effect on its business should the supplier fail to perform, or should the costs escalate beyond what has been budgeted. Much emphasis is accordingly placed on getting "value" from the deal, not just at its outset but also through the remainder of the contract term.

Why Is Maintaining Value Important?

From a client perspective, maintaining value is usually embodied in price controls and review, and ongoing service incentives. If such matters are not addressed in the contract at the outset, the balance of negotiating power will have swung firmly to the supplier, who may seek to squeeze maximum fees from the client for the minimum possible level of service (at least during the early days of the contract, i.e. before the "carrot" of contract renewal or extension is in view). Suppliers are of course used to seeing service incentive and price control provisions on such contracts, but will be concerned to ensure that they are set at a realistic level, so as not to unnecessarily inflate the cost of providing the service (which may make the supplier’s bid seem uncompetitive), or put it at risk of incurring financial penalties when its level of service is, objectively speaking, adequate.

What Are The Tools?

There are 4 key mechanisms for maintaining value in a long term outsource deal namely:

  • Service Levels and Credits
  • Benchmarking
  • Cost Controls
  • Break clauses and termination rights

These are considered in turn, below.

1. Service Levels And Credits

Service Levels are probably the most obvious incentives/monitoring tools which come to mind when considering long term service arrangements. Put simply, they are the means by which the client specifies the expected level of quality for the services it is to receive, and the financial implications for the supplier should the actual delivery experience be less than was expected. The nature of the service levels will obviously depend on the nature of the services being outsourced; common examples in an IT context, however, will include:

  • Time to respond to/fix notified errors or problems with the outsourced estate;
  • Levels of availability of the outsourced systems;
  • Response times, in terms of the speed of completing defined instructions;
  • Packet loss/delay, e.g. the number and/or proportion of data packets sent between particular nodes which are lost or delayed in transit;
  • Adherence to budgets/timescales; or
  • Performance by reference to a "scorecard" (usually incorporating a number of subjective as well as objective considerations).

Undoubtedly, service levels provide an essential mechanism for keeping track of the quality of the services being provided, and keeping a supplier’s mind focussed upon not only setting its service function up correctly at the outset of the contract, but also maintaining a consistent level of service thereafter (for fear of having its margins eroded or wiped out altogether by the application of service credits if it fails to do so). However, simply setting a service level is just the start of the process; other factors to consider include:

(a) The amounts to be placed "at risk"; should there be a limit, and if so should it be an absolute amount or set at a percentage of the supplier’s revenue?

(b) Over what period should performance be measured? The shorter the period, the more onerous the regime will be (as there will be less scope for a supplier to "even out" isolated blips in its service provision).

(c) What will happen once any cap on service credits has been met? Will this simply be the limit of the supplier’s liability, or will such poor performance trigger any additional rights, such as a right of termination or for the client to "step in" to provide the deficient services itself or via another provider?

(d)Whether the supplier will get any kind of bonus for exceeding the defined service levels, either individually or on a consistent basis, or at least have an ability to "earn back" service credits otherwise incurred by establishing a pattern of consistently better performed services during the subsequent measurement periods?

(e) Whether service credits will constitute the supplier’s sole and exclusive remedy for the failures in question, or whether the supplier will in any event also remain potentially exposed to damages claims by the client.

(f) How will performance actually be measured? Will it be automated and therefore objectively verifiable, or will it be the responsibility of one or other of the parties to measure it? What will the parties do if they dispute such measurements?

(g) Can the service levels be adjusted over time, e.g. to reflect advances in technology or simply new areas of activity or business imperatives on the part of the client?

2. Benchmarking

Benchmarking has over time become established as a key component in longer term outsource deals, as a means for a client to compare the fees and levels of service received from its supplier against what is common (or at least readily attainable) in the wider market. It invariably involves engaging a third party consultant (from organisations such as Gartner or Compass) to carry out an analysis of identified services or elements of the fees, so as to "benchmark" them against comparitors in the market.

As ever, the devil is in the detail. There may be difficulties in establishing a statistically significant set of other projects/contracts which are sufficiently similar to that which is to be benchmarked, and the market is in any event fast moving (especially with the distorting effect of off-shore outsource suppliers, who operate on the basis of a completely different cost base). Even if reasonable comparitors are available, the parties must agree what the results of the benchmarking exercise will be; will it, for example, simply trigger "discussions" between the parties, or will adverse findings result in the supplier being bound to raise its service levels or lower its charges? If price reductions are to be made, will the reductions be to the lowest price identified by the benchmarking process, the median price or the one at the top of the range of "reasonable" fees? Might the supplier even receive some kind of bonus or uplift if the benchmarking exercise finds its level of service is abnormally high, or that it is providing a particularly cost-effective service?

Failing to address such issues at the outset can be disastrous; in the recent highly publicised spat between Cable & Wireless and IBM, there was nothing in the contract to explain what would happen in the event of an adverse benchmarking report, beyond the obligation to produce a remedial plan. IBM was so incensed with the findings of the benchmarker’s report on their services that they refused to produce a plan until the exercise was redone, leading in turn to Cable & Wireless commencing a multimillion pound law suit against IBM and terminating the underlying outsourcing contract.

3. Cost Controls

There are various ways in which the contract’s cost and price provisions can be adjusted so as to retain the essential flexibility required to ensure that the contract remains relevant to the changing requirements of the business. They include:

(a) Budget Overruns – i.e. setting target prices or budgets for any work to be undertaken on a time and materials basis, and providing that the supplier’s fee rates will gradually be reduced the further over budget it goes. Conversely, the supplier can be rewarded for bringing in a project successfully under budget by an additional payment of a percentage of the delta between its actual costs and its target/budget.

(b) "Arks and Rooks" – when the actual scope of use or a service is unclear or is likely to vary considerably over time, it may be impossible to come up with a meaningful fixed fee; in such circumstances, a preferable approach may be to implement a usage-based pricing scheme (whether based upon numbers of units/transactions processed, number of FTE staff replaced or otherwise); having set a baseline for such usage pricing, this can then be adjusted upwards if the requirements grow (Additional Resource Costs – ARC’s or "Arks"), or downwards if the needs of the business decrease (Reduced Resource Costs – RRC’s or "Rooks"). Such a mechanism will often be linked to ceiling and basement levels for the client and supplier respectively, which will trigger rights of renegotiation and, potentially, termination once the figures reveal the circumstances faced by the parties have so far altered from what was originally envisaged that a new approach is required.

(c) Transparency of Pricing – clients may be suspicious of an outsource supplier’s costs projections, on the basis that once they have committed to the contract, the supplier may be able to "run away" with the service and end up charging substantial amounts over and above what was originally envisaged, thus depriving the client of much if not all of its projected financial benefit. One way to provide reassurance that this is not the case is to require the supplier to disclose its actual level of profit from the contract (often termed "open book" accounting, a method which is particularly prevalent in public sector outsourcing deals). To this can be added a provision whereby any profit in excess of a defined cap is then remitted, either in whole or (more usually) in part to the client, by way of payment rebates ("gainsharing").

4. Termination & Break Clauses

Ultimately, the only way to ensure that value for the business is maintained may be to actually bring an outsourcing deal to an end; this could be because the supplier’s performance has not met expectations, but may equally be because the needs of the business have changed so dramatically that there is no longer any "fit" between it and outsource provider.

What is key in such circumstances is to try to ensure that the parties have certainty not only as to when the contract can be terminated (e.g. upon specified break events, upon notice, upon adverse benchmark findings, when service levels dip below specified thresholds, or perhaps at certain identified break points) but also as to the consequences of termination. This will extend considerably beyond the potential payment of damages, so as to also include return of data, information and assets, the transfer of staff under TUPE, the provision of assistance to an incoming replacement supplier, and possibly an obligation for the supplier to continue providing some or all of its services for a defined period, notwithstanding the termination of the overall contract. Where the supplier is not itself at fault, it will want certainty as to its rights (particularly as to payment and protection of its confidential information and IPR).

Conclusion

With the accumulated learning from the increasing volume of past outsourcing projects, and the occasional horror stories from those which have gone wrong, one can see the similarities between outsourcing and a successful marriage; they need to be entered into after a great deal of thought and preparation, and require considerable flexibility as they proceed. However, one could add that outsourcing is perhaps more like a Hollywood style liaison, in that each such marriage also requires a thorough pre-nuptial agreement to ensure that both parties understand what they might be taking out, as well as putting in!

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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