Contract flexibility and integrity are significant contributors to the overall costs that a customer pays over the lifetime of an outsourcing relationship, says attorney Robert Zahler a partner at the law firm of Shaw Pittman in Washington, DC. Customers with relatively inflexible contracts usually wind up paying more for services than they anticipated and more than other companies with more flexible contracts. So working flexibility into the contract and assuring integrity are often considered the most important things to pursue in an outsourcing relationship.
The two most important factors to consider in having a flexible contract are interrelated. The first is determining what work is “in scope” and what work is “out of scope.” And the second related issue is how to price the in-scope work and the out-of-scope work.
“Vendors view outsourcing contracts as a snap shot in time,” Zahler says. “When the vendor takes over, it basically will do what its client was doing before it took over. But while that snapshot provides the base for the relationship, the picture that is captured is actually dynamic and in change.”
Every company, just before they outsource, is spending money on new things like personal computers, new printing processes or new operating systems, he says. So, when the snapshot is taken, it a snapshot of that dynamic change and the key is to make sure that the outsourcing contract isn’t static.
Defining the Scope of the Contract
Some of the dynamic change is “in scope,” and some is “out of scope,” but both are important, Zahler says. First, there is a set of base services that are in scope. The base services evolve and change over time as technology changes. Things that are not in the definition of base services are characterized as either new services or additional services. These services are out of scope and the assumption is that these additional services will increase costs.
“It is difficult to determine what services are in scope and which are out of scope,” Zahler says. “(Contract attorneys and consultants) often use word formulas to help the parties determine in any particular circumstance whether something should be included within the base or something should be additional. Those word formulas don’t resolve the issue, but they create a framework for discussion.”
One formula that is used to help initiate a discussion states that the product is a new service or an additional service if it is something that is “materially different from and in addition to” the services that were previously provided, he says. What attorneys and consultants try to capture in those words is that if something is merely a replacement service, like switching computer models, then it is not materially different. And even if a vendor switched from, for example, paper reports to CD-Rom reports, that may not be considered “materially different and in addition to,” but then again in some cases it might be. It depends on the circumstances. Again, the idea behind the word formula is only to spark a discussion about whether or not it is.
Often, a base case or an economic model is created that explains what the company was doing before it outsourced and what the company would be doing now if it had not outsourced, he adds. So a word formula could be generated based on whether or not it is “included in or contemplated by” the base case. If it isn’t then it would be an additional or a new service, and out of scope. Again, it won’t solve the problem, but allows the parties to have a discussion.
Flexing the Service Levels
Service levels state what services the vendor will provide and the quality level that the services will be performed at. For example, the server will be up and running 99.8 percent of the time. One of the things that Zahler and others are beginning to do is called continuous improvement service levels. The idea behind continuous improvement is that the service levels should change based on an approach towards improving performance.
“One approach is to set an initial baseline for service level performance,” Zahler says. “After one year, the client measures the vendor’s performance and records it. If the actual performance is better than the service level, which is almost always the case, the vendor increases the service level to half of the difference between the actual performance and the original service level number, so that a new base is set.”
If the performance is less than the service level, then the prime doesn’t change. This process continues every twelve months, he says. It allows flexibility and also assures that the integrity of the contract remains intact because the client continues to get better service and the vendor isn’t forced into anything that it isn’t capable of doing and incurs no additional costs.
The Impact of Acquisitions, Divestions and Mergers
Contracts should attempt to manage a situation where a lot more or less production is obtained. Typically the pricing for these deals is in two parts. One is a fixed price for a base line level of services. So if a company is talking about the mainframe computer, the baseline might be based on the amount of CPU units, gigabytes of storage and/or amount of tape used, Zahler says. The vendor measures how many units, gigabytes or tape is used and if the company uses the exact amount set forth in the contract, the baseline amount, then the company pays the fixed price. If a company uses more than the baseline amount then an additional resource charge (ARC) will be implemented, and the company will pay the additional charge for the usage above the baseline.
“The usage above the baseline is tiered so that as the volume increases the pricing percentage decreases,” Zahler says. “There are various tiers depending on the volume that you have and as volume increases a company will get greater and greater discounts.”
If a company’s production falls below the baseline it will get what is called a reduced resource credit (RRC) and it will be a credited up to the baseline amount. But both the ARCs and the RRCs have limits, which usually fall between plus or minus 30 to 50 percent, he says. So at some point a company is going to fall outside of what has been priced and that is when it has to have something in the contract that discusses acquisitions and divestions, which are usually the reason behind such a significant change.
Benchmarking For Integrity
Zahler suggests that customers include a benchmarking clause, which means that once every two years or so the client has the right to go out and benchmark the services and price against other vendors in the marketplace.
“Almost every contract that we have done, including the ones from the late ’80s, have that type of clause,” Zahler says. “But in reality very few, if any, went out and actually benchmarked.”
Because of this, he is trying to write benchmarking clauses that are much more specific about how the benchmarking will be done – what process will be followed and what the result will be. The results can be one of several options including using the best price, the average price or the price of the top 20 percent. He feels that if the clause is more specific then it will be an easier process and the customers may actually do it. .
Zahler says there are many options that can be used to add flexibility and integrity to contracts, but it all comes down to what a company pays for. One of the reasons that companies outsource is because they want to allocate risk by shifting some of the uncertainty of information technology (IT) activities to the vendors. Vendors price services based on some assumed level of risk and if the customer asks for a lot more risk allocation then it is likely to get a higher price.
“What we try to do with flexibility provisions is to hit the golden spot, to balance the right amount of risk for the right amount that the client is prepared to pay,” he says. “If the client is willing to pay a lot then the vendor will take on a whole lot of risk. If the customer pays less, then the vendor will want to take on much less risk. And so flexibility is really another way of saying, ‘how do you balance the risk between the customer and the vendor.'”
Lessons From the Outsourcing Primer:
- Outsourcing relationships are always changing so contracts should be dynamic as well, in order for the arrangement to be successful.
- Out-of-scope services are additional services and therefore usually cost extra money.
- Contracts should attempt to manage a situation where more or less production is obtained.