By December 1, 1997 Read More →

Benchmarking Begins with the Contract | Article

penContinuous rapid change in technology that, in turn, drives changes in pricing and service levels dictates that the outsourcing customer have some mechanism for ensuring continuous improvement in its contracted pricing and service levels. Benchmarking is one of a number of tools used by outsourcing customers to maintain flexibility in their long-term outsourcing contracts. In recent years, including benchmarking provisions in outsourcing contracts has become a common practice.

The general purpose of such a provision is to permit a party to the contract to initiate a process by which the parties’ contractual pricing for services or service level agreements are benchmarked against comparable situations. The contractual provision will normally require adjustments in the contract pricing or service levels to the benchmarked level.

Many customers negotiating outsourcing contracts for the first time are surprised to learn that benchmarking results are not precise and definite. The results, instead, provide a range of outcomes which the parties then use in negotiating pricing or service level adjustments. At the contract stage, much of the negotiation of benchmarking involves agreement to a structure for the procedure and the type of information that will be used in the analysis.

Customers should understand the typical terms included in a benchmarking provision.

Who Does What…and When

First, the parties will need to agree on which party or parties may initiate a benchmark, when it may be initiated and who the benchmarker will be. Generally, the customer is the one negotiating a benchmarking provision for its protection, so it is not unusual that only the customer, and not the outsourcing vendor, be entitled to initiate the procedure. Many times, however, the parties to an outsourcing contract will negotiate “substantial change” provisions that address the parties’ respective rights in cases where there are substantial increases or decreases in the outsourced services. In such a case, the vendor may negotiate for the right to initiate a benchmark if it believes its profit margin has been reduced for reasons beyond its control.

Next, the parties will negotiate when the benchmark may be triggered. Some customers may feel comfortable that benchmarking of prices will not be required for the first year or possibly second year of the contract term. In the case of service level benchmarking, however, the customer may want that right after the first year of the contract. Usually, the parties will agree to limit the frequency of a benchmarking to once per annual period. [Customers should be aware of the “lag time” factor. As a result of the time required to complete the benchmarking procedure and the dated nature of the benchmark data, the data will be anywhere from six months to a year old.] The parties also will need to address whether both service levels and pricing must be benchmarked together or whether they may be benchmarked separately.

The provisions for selecting the benchmarker may be structured several ways. The parties may specify one or more benchmarkers by name and allow the customer to select from the list. The parties may require that they both mutually agree on the benchmarker. If so, the provision normally will include examples of the type of benchmarker they would choose, in order to avoid any† misunderstanding of their mutual expectations. Both parties will be concerned with the credibility and capabilities of the benchmarker, as well as the costs involved for the benchmark. These can differ widely,† depending on whether a nationally recognized benchmarker or a smaller, less known benchmarker is selected.

The scope of the benchmark itself often requires a great deal of negotiation by the parties. Both parties are best served when the scope is designed to provide the most comparable benchmark data possible. That can be complicated. In data center outsourcing, for example, the confidential nature of these deals can impose severe limitations on both the quantity and the quality of the data that can be obtained by the benchmarker.

Other factors also need to be included in the benchmark procedure to ensure normalization of the results to the particular situation being studied. For example, any investments made by the outsourcer on behalf of the customer — purchase of equipment, assumption of lease costs or software related costs — must be considered to the extent that amortization of these investments are reflected in the outsourcer’s pricing. Any peculiarities of the customer’s processing environment, such as unique customer requirements for non-standard systems software, also should be taken into account. Outsourcers also will request that the contract term length, level of committed processing volumes and other terms of the customer’s deal be considered as a normalizing factor.

Before the Gloves Come off…

Finally, the parties will need to determine how disputes related to benchmarking results will be handled. Normally, the preferred method is to include a contract provision for an “internal” dispute resolution procedure involving one or more joint operating and executive committees. The parties must understand that — particularly in the area of benchmarking — the “dispute” may simply be a failure of two reasonable parties to reach agreement based on a range of possible choices. In that case, the “dispute” is not a legal issue that can be appropriately decided by an arbitrator or judicial officer. Therefore, the parties may need to provide for a tie-breaker mechanism short of submitting the disagreement to a formal dispute resolution procedure.

Effective benchmarking begins at the contract stage. Parties to outsourcing contracts need to spend quality time developing contractual benchmarking procedures appropriate to their situation. While these procedures can prove beneficial in a long-term outsourcing† relationship, they are not a panacea.

Parties embarking on a contractual relationship must understand that benchmarking procedures have limitations. Awareness of both limitations and benefits is essential in the structuring of benchmarking procedures that will strengthen, rather than divide, the relationship.

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