Outsourcing Roadmap Index

The outsourcing contract is one of the most important document in an outsourcing relationship. The contract, terms and the quality of the contract will largely influence the outsourcing relations, governance and overall the success of the outsourcing venture.

In order to take full advantage of outsourcing and minimise risks all involved parties should carefully consider a few guidelines;

Align the goals and objectives of both the service provider and the customer

Measure accurately what work is being accomplished. Match the work performed with invoices.

Accurately forecast the demand for outsourced resource.

Jointly, with the service provider, innovate, re-engineer work processes and achieve technology innovation to improve productivity, efficiency and quality. Use rewards and incentives for innovation and improvements.

Build in the contract gainsharing, incentives and penalties.

Ensure transparency and accountability. This will largely determine the development of the outsourcing relationship

Plan for change. Build in as much flexibility as possible. Negotiate and re-negotiate agreements, SOW (Statement of Work), SLA, etc. The contract must provide enough flexibility to meet unforeseen demand changes upward or downward. Effective outsourcing contract negotiation requires that needs, business and technology requirements, projected demand growth, peak periods, projected business shifts, and required service levels are all known.

Manage contract cycle, maintain version history and control change process. Keep the contract and related documents (SLA for instance) up to date.

Hope for the best but prepare for the worst. Be realistic. After the “honeymoon” is over difficult issues might arise along the way and hurt the outsourcing relationship badly. Preparation should start before the contract is signed. Be clear on dispute resolution, termination rights, change control, approval process, intellectual property ownership and handling of subcontractors. Have a clear exit strategy.

Pricing should be negotiated in order to reflect planned growth and projected as well as un-projected peak demand. Wherever possible, demand should be quantified in advance to obtain a more favorable price. Un-projected demand will likely drive costs higher because of the service provider's motivation to build as much into the annuity portion of the contract as possible. Reserve the right to renegotiate requirements and pricing if necessary

Today, contracts between the customer and the service provider(s) generally fall into one of the following categories;

Labor based contracts. There is an hourly or monthly labor rate assigned to different skill levels. Here the contract anticipates a general volume of work, has quality of service goals, and places constraints on the total labor anticipated for accomplishing the work within that framework. In this type of contract there is little to no incentive for the service provider to improve efficiency, since the result is fewer billable hours and less revenue.

Transaction based contracts. The service provider is paid for completed transactions. Usually there are service quality goals, as well as expected transaction volume. This type of contract could encourage the service provider to find ways to be more efficient to process more transactions with the same resources. This type of contract is typical for BPO services.

Goal based contracts – gainsharing. The customer and the service provider establish efficiency and effectiveness goals together in a way that it encourages improvements. This is accomplished as a result of transparency and accountability. The customer and the service provider can jointly investigate efficiency and effectiveness initiatives, quantify the potential impact, and share the benefits of achieving the goal of the initiative.

Key terms to negotiate

The most difficult issues that arise in the outsourcing transaction involve pricing and service levels and how the parties measure performance and adjust for changes in the customer’s needs and the business and technology environment in which they are operating.

To resolve those issues it is necessary to examine and understand the different perspectives of the supplier and the customer.

The customer is turning to the supplier for its expertise in providing various services and dealing with technology and/or business process issues in a professional, cost effective manner. The customer wants the supplier to take responsibility for the operation of a portion or all parts of the outsourced functions/process. The customer, however, is dependent to a certain degree (see What to outsource) upon the outsourced functions for the success of its business. Accordingly the customer wants to be sure that it achieves the predefined goals of outsourcing (see Why outsourcing), gets quality service at the lowest price.

The supplier, on the other hand, wants a long-term, profitable relationship. At the same time it has to be concerned about any threats against its return on investment such as financial penalties for failure to meet service levels or missing deadlines, re-pricing or re-scoping as a result of benchmarking. These are threats to the supplier’s profitability and the return on investment.

Scope and change control

One very important area of concern to both customer and supplier is the scope of the work to be undertaken. It is almost impossible to properly price an outsourcing transaction until the scope of the work to be done is clearly and accurately defined. Establishing properly what is in the scope and what is out of the scope is important to both parties. For the supplier, defining what is within scope defines what they have to do and deliver. For the customer, it is important to understand what they are getting for the agreed upon price and how “out of scope” items will be handled and charged.

Having established what is the scope of the outsourcing venture, it is important to put in place a solid change control process in order to permit changes to the scope over time. Changes most probably will occur over the course of an outsourcing contract. It is likely that the business of the customer, technology, competition and other factors will change. Scope and services must be reviewed regularly. An agreed upon process must be in place to review any request for changes and to decide what is in scope. This will allow both parties to know at any point in time what is to be done. It also will permit the parties to consider the implications of changes on pricing, service levels and governance.

Service Level

Once the work to be done has been determined the partners must decide how and when it is to be done. What level of service does the customer need or want? Pricing and service levels are closely linked. The challenge is to achieve the goals of the outsourcing venture without sacrificing service level. The important step in establishing expected service levels is to determine what level of service the customer has been receiving internally or from other vendors. This can serve as a baseline for the contract.

The second important step is to determine the consequences of failure to meet service level requirements. Will there be credits against future fees or any penalties? When will they be triggered? Will there be the opportunity to earn back lost revenue through rewards for improved service? Gainsharing might be a model to consider when asking these questions.

Pricing

There are a few different pricing models that are used in outsourcing transactions. While the customer will want to get the best price possible, it is important for the customer to understand that if the long term relationship is to succeed the suppler must make a reasonable return on its investment. A supplier that thinks that it is being underpaid will try to find ways to reduce its costs or increase the customer’s fees. It works against efficiency and poison the outsourcing relationship. The goal is to pay a fair fee for services provided. However, it is very important to understand by customers that pricing is determined by many factors, such as complexity of the work, resource requirements, service level expectations, length of the contract, scope of work, technology and many others.

The three basic pricing models:

Fixed Price: the supplier is paid a fixed, pre-agreed amount upon delivery. When this pricing model is used the requirements, scope, services, features, planning and timing, and pretty much everything, is also fixed. For customers it provides greater cost certainty but leaves most of the risks with the supplier. However flexibility is limited and changes can be expensive. It can also have a dramatic negative impact on service delivery and service levels. Fixed pricing is adequate when there are only a few unknown factors and no significant changes are expected.

Time and Material: the supplier is paid based on the time and material used. In principle, when this type of pricing is used the customer pays only for what has been used. The key to success is accountability and transparent administration on the supplier side. However, this type of pricing does not encourage the supplier to increase efficiency and provides limited cost control options for the customer. It can also hide mistakes on the supplier side. An absolute must is a "not to exceed" figure in the contract.

Cost Plus: payment is based on the actual cost of production plus an agreed-upon fee or rate of profit. This pricing model has a low administrative overhead and provides good transparency. However, the customer must bear most of the risks and the pricing model provides limited cost control which encourages operational inefficiencies.

In reality often a mix of the above pricing models are used. For example in a software project for the design phase Time and Material pricing is used while Fixed Pricing is applied for the implementation phase (when the requirements are already well known, documented and fixed).

Assessment

How does the customer ensures that its pricing and service levels remain competitive over a 4 to 7 year period? There is need for periodic reassessment of the terms of the agreement to deal with changes in technology, market, environment, business, goals and others. Benchmarking is the tool to regularly asses if current pricing, service levels and other aspects are in accordance with expectations and industry standards. An independent third party is contracted to report back to the supplier and the customer on current service levels and pricing.

Flexibility

Given the fact that many of the issues in an outsourcing relationship are going to be arguable and that the outsourcing arrangement is a long-term agreement, mechanisms like audit, regular reporting, meetings and periodic assessments can serve to resolve issues at an early stage. They provide means for the contracting parties to monitor and adjust performance as appropriate over the course of the agreement.

Overly rigid control mechanism works against innovation and efficiency. It is important to keep in mind that the customer has chosen to outsource a function or process to a certain service provider because it has confidence in the expertise of the supplier. In order to achieve positive results on the long term service providers have to be able to adapt to changed circumstances and the changing needs of the customer.

The contents of an outsourcing contract

The scope and detailed definition and description of services and/or products to be delivered.

Provide a clear statement on the rights and obligations of both parties, so that each party know what it must do under the agreement and what benefits it will receive in return.

Governance structure, representation and reporting requirements

General conditions about security, privacy and warranties

Set out the plan and schedule that will apply to the delivery and implementation of the products and services specified in the agreement.

Provide a clear procedure for the parties to control changes to the project and agree on the impact that any changes will have on the timetable and the price.

Set out the basis by which the customer will measure and accept the services/products delivered and how the payment(s) will then apply.

Define the procedures to resolve any disputes promptly and provide effective and commercially realistic remedies for both parties in the event of contractual default by the other. It also should include any limitation of liability, termination and re-negotiation conditions.

Define any ownership of rights, products, licenses and intellectual property.