Valuing Contract Terms in Outsourcing Contracts | Article

handshake, outsourcing contractsIf you are an outsourcing customer, an outsourcing agreement is like a three-legged stool. Its value depends on what you agree to buy, what you agree to pay and the terms of the contract. Although the agreement and the other contract terms are often extensive, outsourcing customers often underestimate, or even overlook, the value in contract terms.

Why Focus on the Value of Contract Terms?

Being able to identify, estimate and articulate the business value of the contract terms in an outsourcing agreement can help you to:

  • Make smart choices between lower prices and better contract terms.
  • Balance the desire to “get it done now” against the value of “doing it right.”
  • Invest appropriate amounts of time and resources in drafting and negotiating contract terms.
  • Focus negotiating energy on the high-value contract issues.
  • Describe to your leadership why it is worth investing in contract terms and how your negotiating success created value for your company.
  • Achieve better results for your company.

The value in contract terms is in securing commitments, obtaining options, aligning incentives and supporting a successful relationship.

Securing Commitments

Contract terms can help to secure a commitment to provide specified products and services at firm prices. That commitment may include contract terms such as sweep clauses, service warranties, rights to make immaterial changes without additional charges, continuous improvement obligations, “all-in” pricing, audit rights, and a clear and complete definition of scope.

Without these contract terms, the pricing is more of a forecast than a commitment. Customers without these contract terms often find themselves compelled to sign change orders and pay unexpected charges to avoid going without vital services.

To estimate the value of one of these provisions, multiply your best estimate of the amount that the supplier could increase charges by exploiting its proposed provision by the probability that the supplier would choose to increase its profits in that way.

Obtaining Options

Contract terms can provide the customer options to, for example, obtain out-of-scope services at reasonable prices, in-source or re-source, change technical or operational requirements, impose reasonable rules and restrictions, relocate customer facilities, change customer technology, adjust prices through benchmarking, have services provided to related companies (including divested companies), terminate the agreement or obtain additional services such as M&A support or termination assistance services.

Options are valuable because they reduce the size and risk of charges for changes; their value increases with the volatility of the markets, which seems to be on the rise. Customers’ financial models tend to overlook the value of options because those models assume that all will go as planned—an increasingly unlikely possibility.

A straightforward approach for calculating the direct economic benefit of an option is by estimating the probability of exercising the option and multiplying that by an estimate of the economic benefit achieved by exercising the option. For example, if the supplier agrees that a termination-for-convenience charge will be reduced by $1 million if related to a change of control, and you estimate a one percent probability that you will terminate related to a change of control, this calculation would be 0.01 x $1,000,000 = $10,000. If you can obtain that provision for less than $10,000, it would be worth obtaining. Scenario analysis, Monte Carlo simulations, the Black-Scholes option pricing model and similar tools can provide better estimates, but even a simple estimate provides better guidance to economic decisions than ignoring the economic effect of contract terms or merely calling it out as a risk.

Another approach to looking at the value of options is to look at whether your business can survive without the ability to change the outsourced part of its operations. As Charles Darwin put it: “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.”

Aligning Incentives

Contract terms can increase incentives for the supplier to act in the customer’s best interest. Contract terms such as service level credits, deliverable credits, holdbacks, obligations for the supplier to correct its errors at its cost, and indemnities against harm caused by the supplier support a successful relationship by aligning the interests of the supplier and the customer. These incentive provisions can also mitigate potential losses by requiring the supplier to pay some of the customer’s losses.

The value you place on incentives depends on your estimates of (i) the value of achieving your desired business outcome, (ii) the supplier’s ability to help you achieve that outcome, and (iii) the strength of the incentive. These estimates require judgment, so a good approach is to collect and aggregate estimates from people whose judgment your company trusts.

The strength of the incentive depends on its size relative to the supplier’s cost of achieving the desired result. Like you, the supplier is looking at the cost versus risk. For every $1 that you want the supplier to invest in reducing a risk by one percent, the supplier should have at least $100 at risk. Any less might make the potential liability more of a cost of doing business than an incentive.

Supporting a Successful Relationship

Contract terms can also support a successful outsourcing relationship by:

  • Building trust. Trust increases when companies are willing to translate their communications into enforceable legal obligations. It is further increased when the contract terms make the two companies, to a degree, accountable to each other as “partners” in sharing the risks and rewards of operating the outsourced scope. Trust allows companies to work seamlessly together.
  • Creating alignment on how to work together. Sourcing contracts create complex, multi- faceted relationships. Agreeing on how to work together allows these relationships to succeed across company boundaries. For example, reporting, governance and information rights simplify the communication process; agreeing on how work will be added or removed reduces the friction at important points in the relationship. Issue management and escalation provisions make it easier to resolve disputes.
  • Giving you an understanding of where and how the supplier will provide the products and services. Contract terms can help you understand your entire supply chain. For example, they can help you understand which subcontractors will be assisting the supplier and what new risks have been introduced (location, handoffs, labor type, disruption, publicity, etc.).

These contract terms are important to obtain the benefits of the commitments, options and incentives obtained in other contract terms. Their value can be estimated using the tools and ideas described for commitments, options and incentives.

Summary

  • The ability to identify, estimate and articulate the business value of the contract terms in an outsourcing agreement leads to better agreements.
  • Contract terms provide value by securing the commitment to defined services for a fixed price, providing options, aligning incentives and supporting a successful relationship.
  • You can estimate the economic value of contract terms and in doing so help your contracts and your company be more successful.


3 Comments on "Valuing Contract Terms in Outsourcing Contracts | Article"

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  1. Melanie says:

    A brilliant article for anybody considering outsourcing! It is important to set terms, like with anything business related.

  2. Afshin says:

    Very nice article.
    We are 2 guys doing our bachelor thesis at IBM in netherlands and our subject is Flexibility in outsourcing contracts.

    We are right now researching how we can use real option theory to put a value on flexibility, but we find it challenging.

    In the article you mention that one can use the Black-Scholes model and we wonder if you have any articles or documents on how to apply that in this matter.

    Thanks in advance

  3. A business process where a task performed internally is being purchased as a service. A good article giving a nice understanding on outsourcing.

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