- • Secure commitments to performance as measured against agreed metrics
• Create an incentive for suppliers to consistently meet those commitments, and
• Obtain options to take action to correct deficient performance
However, a poorly crafted or supplier-favorable SLA can instead reduce the supplier’s obligations and incentives to perform well. Too often, we hear that the service level dashboard is green (as reported by the supplier) when actual operational conditions are red (at least as perceived by the customer stakeholders). The goal of this article is to help customers craft service levels that provide commitments, options and incentives leading to long-term success.
The first and most important step in developing an effective SLA is to ask the right questions. This article proposes 10 key questions to ask and some background on how to choose the right answers.
1. What service levels will you include in the SLA?
Service levels generally measure the quality, speed, availability, capacity, reliability, user-friendliness, timeliness, conformity, efficiency or effectiveness of services. For example, an availability service level for a server might be the percentage of the minutes during a month when the server is capable of performing a specific task. By contrast, achievement of one-time events, such as go-live, is best handled by requiring the supplier to achieve a defined milestone by a specific data, perhaps with a credit applied if the milestone is not achieved by that date.
In deciding which service levels to include in your SLA, consider at least the following factors:
- Strong correlation with the value that the supplier delivers. Seek service levels that measure outcomes that improve efficiency, increase sales and so forth and avoid merely counting activities that suppliers perform.
- Availability of reliable data to assess actual performance. For example, invoice processing time might be tracked with great accuracy through the customer’s accounting systems while the number of internal controls failures might be difficult or impossible to measure.
- Whether other legal or contractual mechanisms are better suited to creating the right incentives. For example, a right to collect damages would provide a better incentive than service levels against data security breaches.
- Focus. Increasing the number of service levels tends to dilute the impact of each individual service level.
Ask this first question at the deal-structuring stage. Ideally, you can craft the scope of services so that the hand-off between the supplier and the customer includes measureable outcomes that indicate value (such as available servers) instead of an activity that correlates less well with value (such as incident response time).
2. What, exactly, will each service level measure?
To have an effective SLA, customers need to carefully define in the contract what each of the service levels will measure. Otherwise, suppliers who have failed to meet service levels may exploit weak points in the drafting to argue that they have achieved service levels despite failing to meet customer expectations.
First, define a clear standard that fits the specific technology and processes. Find people who understand the operation well and ask questions to probe the boundaries, particularly in those places where work needs to be correct and complete to provide value. For example, there may be no value in supplier’s server being available unless supplier’s network is also working.
Second, define a formula for calculating the end result. For example, that might be the total number of measured items that meet the standard divided by the total number of measured items and expressed as a percentage. A specific formula will bring clarity to the definition and will be necessary for later steps.
3. How will actual performance be measured?
For each service level, you need a method for measuring actual performance. For example, you could measure a computer system’s availability software continuously running within that computer system, periodic polling by another computer system, user complaints about downtime, or a monthly user-satisfaction survey asking about perceptions of downtime.
The measurement method will affect the reported results. In that example, availability will be lower when measured by a software system that picks up every millisecond of downtime than it will be when measured only by user complaints. Thus, you need to know how service levels will be measured before you can decide how high to set the bar for performance.
The key issues in choosing a measurement process include:
- Accuracy. A measurement process with a large margin of error puts more risk into the deal than one with a small margin of error.
- Cost. The cost of a measurement process includes both the cost of running the measurement system and the burden that the process places on the people, computers and other resources that could otherwise be performing services.
- Visibility. A good measurement system allows both parties real-time access to data and the ability to audit historical data.
If you cannot identify an effective measurement process, reconsider the service level. A service level that cannot be measured well invites disputes and disappointment.
4. What will the measurement period be?
The measurement period is the time horizon for measuring performance. Typically, the measurement period will be a month or quarter. Longer measurement periods give the supplier more opportunity to make up for bad performance. Shorter measurement periods give the supplier a “fresh start” more often. Longer measurement periods mean that more is at stake than during any one measurement period.
The SLA should define not only how long the measurement period is but also how much of that time is within the measurement period. Is it 24×7 or 9×5? Does it include times when the supplier is shut down due to severe weather, acts of war, terrorism, failure of its suppliers or other traditional force majeure events? Does it include periods when the demand for services exceeds the assumed levels? Can the supplier exclude periods by scheduling “maintenance windows”?
5. What reports will the supplier provide?
The SLA should require the supplier to make available clear, useful and timely reports on performance for each measurement period. Ideally, the SLA will define the information that will appear on the reports, such as exception reports for missed service levels and trend reports for key service levels. The SLA might also require the supplier to provide other information as requested by the customer and to conduct a root-cause analysis of service-level failures and report the results to the customer.
6. How well will the supplier agree to perform?
Note that we’re at question number six, not question number one. Too often, people start with the number — say, 99 percent — and then start to define a service level. That’s can lead to poor results because the number is only meaningful when you know what’s being measured, who will measure it, how it will be measured and how often it will be reported.
The SLA often includes both minimum service levels and expected service levels. The supplier would be obligated to meet any minimum service levels, and failing to do so would be a breach of the outsourcing contract. The expected service levels would be measured, and there might be service level credits associated with failure to meet them, but a failure would not be a breach of the contract unless there are multiple failures within a specified period.
Customers should be wary of these pitfalls:
- Agreeing to poor existing service levels. Some customers agree that the required service levels will be set based on existing performance. By doing so, they may preserve poor service quality that the sourcing was designed to improve.
- Agreeing to agree on service levels. Some customers, eager to sign a contract, agree to work out service levels later. However, once the contract is signed, the deal team disperses and the supplier has no incentive to agree to challenging service levels. This often results in no service levels being developed.
- Agreeing to set service levels at initial supplier performance. Some customers, with no basis for setting service levels, agree to set them at whatever levels the supplier achieves during the initial months of the contract. This creates an incentive to deliver low service levels during those initial transitional months, which can be the most perilous time in the contract term.
- Failing to think the incentives through. Customers often create new problems in their effort to solve existing problems. For example, in a call center outsourcing, a customer might set a service level of “answer 90 percent of calls within two minutes” without realizing that it creates an incentive to ignore any call that’s gone over two minutes in favor of any call that could still be answered in two minutes.
- Asking for the best instead of the most cost-effective. Providing better service requires the supplier to use, for example, redundant systems, excess capacity and better technology. Asking for better service than you need means paying more than you need to pay.
7. Will the minimum and expected service levels change over time?
The SLA may include automatic adjustments to service level requirements. Those adjustments are particularly valuable for transformative transactions and for sourcing areas where the customer believes that it needs to steadily improve its own performance to keep pace with its markets. SLAs may increase the performance commitments through:
- Contractual ramp-ups. The SLA can include a fixed schedule of increasing requirements.
- Technology or process triggers. For example, service-level requirements might improve when the customer completes an upgrade to systems used by the supplier in delivering services.
- Supplier performance. The SLA can ramp up the performance requirement based on the supplier’s actual performance. For example, for each year, the target performance could be increased by a percentage of the amount by which the supplier’s actual prior-year performance exceeded the target performance.
8. Will the SLA include service-level credits?
A “service-level credit” is a credit that the supplier grants to the customer after a service-level failure. The supplier may be required to write a check to the customer, or the customer may simply have the right to apply the credit to future service. Either way, it reduces the effective price of the services and the supplier’s profit margin.
As an example, an SLA might call for service level credits for any of 10 service levels. For each of those 10 service levels, the SLA might indicate an amount that the supplier will grant as credit to the customer upon a failure. SLAs often provide that the total service level credits for a measurement period are capped at an “At Risk Amount” equal to a percentage of the supplier’s invoiced amounts. The total pool of possible service level credits (that is, the total service level credits payable if the supplier misses every service level) would then be some multiple of the cap. The pool is then allocated to the credits and can be reallocated as conditions change.
There are many variations on this theme. Some SLAs impose credits only for repeatedly missing required service levels. Some SLAs allow the supplier to earn back service-level credits for subsequent superior performance, or to use superior performance to avoid future service level credits. Some SLAs specify larger service level credits for larger or repeated failures, perhaps even beyond the At Risk Amount.
Generally, service-level credits are intended as incentives not as compensation or sole remedies for the failures. Thus, the customer would retain the right to collect damages to the extent in excess of the credits. However, the credits have substantial advantages over damages because they are easier to collect and not subject to arguments that the damages are waived as consequential or other indirect damages.
9. Will the supplier have the right to service-level bonuses?
A service-level bonus is an increase in the price triggered by performance above the target service levels. They are far less common than service-level credits because, generally, the customer buys the level of service that the customer needs and is not inclined to pay for better service that it needs. In most cases, if the supplier has an opportunity for increased compensation, it is tied directly to creating business value through, for example, a commission on sales made through the supplier’s call center or a gain-sharing arrangement based on actual measurable gain for the customer.
10. What other options will the customer have in the event of service-level failures?
Most outsourcing agreements can be terminated for cause if there is a material breach. A sufficiently severe service-level failure would be a material breach. However, without clear language in the SLA, the parties might argue about whether a service-level failure is sufficiently severe to be a material breach.
The SLA can provide increased certainty by defining particular events that, without argument, allow termination for cause. You can set minimum service levels at the level that allows termination. You can also define an amount of accumulated service-level failures that allow termination for cause. For example, termination for cause might be allowed if the supplier breaches a single service level three times in succession or the supplier breaches enough service levels that the service level credits exceed a percentage of the cap. The effect is to give the customer a clear exit right for substandard performance.
The SLA can also provide other rights and remedies triggered by service-level failures. For example, the SLA may require a root-cause analysis and implementation of agreed activities for permanently correcting the root cause of the failure. Again, care should be taken not to limit other remedies by providing specific remedies.
- Developing the right SLA starts with asking the right questions.
- Define what service levels you will use and exactly how you will measure them before setting performance expectations.
- A good SLA aligns the supplier’s incentives with the customer’s objectives using service-level credits and other rights and remedies.
- To end up with a good SLA, you need not just a good template but a careful analysis of the business function.
Attorney Brad Peterson is a partner in the Business & Technology Sourcing practice at Mayer Brown LLP in Chicago. You can reach him at [email protected].