See our Outsourcing Provider Directory here

Research & Insight

Research & Insight

contract

Valuing Terms in Outsourcing Contracts

Brad L. Peterson, Partner, Mayer Brown LLP

If you are an outsourcing customer, outsourcing contracts are like a three-legged stool. Their value depends on what you agree to buy, what you agree to pay and the terms. 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 the Terms for Outsourcing Contracts? 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 …

Award-Winning Outsourcing Relationships — Three Key Ingredients in their "Secret Sauce"

Linda Tuck Chapman, President, ONTALA Performance Solutions Ltd.

Behind each award-winning global outsourcing relationship is a fascinating story of extraordinary people, excellence in service delivery, lots of sweat equity, some painful bumps in the road, a mutual willingness to constructively solve problems, and trust earned. Contracts were awarded as a result of a competitive bid, so they started with a blank recipe card. While you may not aspire to win the Outsourcing Center’s annual Outsourcing Excellence Awards for global excellence in several categories, every outsourcing relationship has the potential to be a winner. The honor of being a judge for the awards and the privilege of hearing their stories help answer, “What are the three key ingredients in their secret sauce?” Ingredient #1: Flexibility and Willingness to Invest In addition to being flexible, every award-winning global outsourcing relationship demonstrated a willingness for service providers to invest additional expertise and even hard dollars to make things work. No nickel and diming here! Interestingly, the majority of relationships faced difficult challenges during transition or in the early days. In every case, openness and honesty on both sides combined with a genuine interest in constructive problem solving laid the foundation for an excellent relationship. And these were not insignificant issues. For example, early in year two of a five-year deal the credit crisis hit the world. The customer asked the service provider to cut their costs. Being sensitive to the commercial needs of each company, the outsourcer recognized they needed to be flexible and creative. They reduced their client’s costs by moving work to the Philippines, which was a new location for the service provider, and met the savings goals. Another similar case was during a client engagement that went through “rocky moments because of the systems integration issues.” When the going got tough, the service provider stepped up to the plate and addressed the necessary issues. They provided the resources their customer needed to do some special recovery work or redesign. In a third case, it became apparent during transition because of major constraints that were unknown during the RFP process that a large body of work was removed from the original contract. The service provider stepped up to the plate, assumed responsibility and gracefully accepted this blow. What can be learned from these hard lessons? In every case the service provider met their customers’ needs and made the necessary investments to resolve the issues even when it meant reduced profitability. And in every case, the customer was open and honest about their issues and willing to sign-off on appropriate changes to services and the contract. No table pounding, no standoffs. Ingredient #2: A Personal Sense of Ownership Service providers and service delivery aren’t always perfect, which leads us to ingredient #2 – personal ownership. What I mean by personal ownership is a willingness to be held accountable for the success of the relationship and the authority to make decisions. For example, a service provider missed their SLAs for three consecutive months, triggering service credits. With many people involved from both sides, the customer and service provider “got into quite a disagreement as to the amount of the service credits and the period they covered.” Too many opinions and politics were getting in the way. Rather than letting the problem put a permanent stain on the relationship, the customer and the service provider assigned one person from each side to reach agreement about what was fair and pragmatic. This gave them a chance to understand the other party’s point of view, to explore options and to appreciate the impact of the final decision. Another example is a service provider’s Operations Manager who really took their customer’s service level expectations seriously. In this case, a third party company proved to be integral to delivering services across the customer’s footprint. The Operations Manager led the process to integrate SLA‘s and now oversees total service delivery for the customer. They are now meeting service levels at no additional charge to the customer for this above-and-beyond service. There are countless examples of services failing to meet expectations or even going off the rails. What distinguishes award-winning relationships is the strong sense of ownership, accountability to make things work, and the authority to make decisions. Ingredient #3: One team, one goal Fundamentally, these are commercial relationships between two companies. Each one has goals and financial and quality targets they must meet in order to satisfy their own management and shareholders. Consistently these award-winning relationships quickly developed a practice of formally establishing joint annual and long-term goals. These goals generally include commitments to improving service quality, process improvement, and managing financial impact. As one service provider described it, “this is not a perfunctory exercise.” The customer’s Chief Operating Officer and the service provider’s CEO are often directly involved, including approving the joint goals and committing necessary resources. One successful relationship was built on a combination of joint goal setting and what they called “embedding leadership behaviors.” These are five key behaviors that both parties agree to model in everything they do together. Customers pragmatically and universally leveraged their service providers’ capabilities, reaping substantial financial and non-financial benefits year after year. One award-winning customer summed it up by saying that their service provider is able to “add value without adding costs.” And the benefits from the service providers’ perspective are relationships that grow over time in size and complexity, bringing them more revenue, increased profitability and highly referenceable accounts. Conclusion There is so much to be learned from these award-winning global outsourcing relationships between industry giants. By studying successful relationships and understanding what makes them great, you can avoid common mistakes and stress. It is said that “those who don’t study history are doomed to repeat it.” If you strive for operational excellence, words like cultural fit, trust, efficiency and transparency are just words unless you invest the time and effort needed to figure out what goes into your secret sauce for outsourcing excellence. Linda Tuck Chapman, President ONTALA Performance Solutions (www.ONTALA.com) is an expert advisor …

Eight Biggest Areas of Risk for Buyers of Outsourcing Services

Outsourcing Center, Kathleen Goolsby, Senior Writer

New delivery models, new pricing models, service providers’ new marketing strategies, moving up the value chain to intellectual arbitrage, new technologies, real-time customer interaction, globalization, and new standards and regulations – these factors set the stage for risks for buyers of outsourcing services in the next two to five years. (Read Forces of Change Shaping Outsourcing Solutions and Upcoming Changes Point to Need for Buyers to Alter Their Way of Thinking for more information on these factors driving change.) Outsourcing Center interviewed leading service providers about the risks they predict buyers will encounter from these developments. Their list of risks and advice for risk mitigation is a wealth of insights for buyers already in an outsourcing relationship as well as those considering future outsourcing initiatives. Risk #1 – Service provider lock-in “The risk of lock-in – being bound to one provider’s specialized products or services because the cost of change is too high – is a very real threat. This is especially important when it comes to data portability and long-term data preservation. It should be separable from any given software application or service. This will become particularly significant in a cloud-computing environment where the IT service provider stores a company’s data at a remote location. Other risks of lock-in include being weighed down by legacy systems and outdated applications that constrain the buyer from adapting to current business demands, as well as a rigid cost structure.” (Russ Daniels, Chief Technology Officer, HP Enterprise Services) “Getting locked in with a service provider that is limited by geographic boundaries or that has limited capacity to invest or provide scalability would create business risk for large enterprises. Lock-in with a provider that is unable to comply with evolving regulations or one that lacks a demonstrated ability to work through disaster scenarios also puts the buyer at risk.” (Abid Ali Neemuchwala, Global Head, TCS BPO Services) Risk #2 – Multisourcing “Using multiple providers is perhaps a good buying decision but not always a good business decision. Each provider demands time and attention. In addition, this results in many small outsourcing relationships that are very narrow in scope and often represent transactional functions rather than higher-value processes that could be outsourced to create far more value and impact enterprise-wide.” (Robert Pryor, Executive Vice President of Sales, Business Development and Marketing, Genpact) “A multisourcing approach opens the market to many smaller providers that previously lacked the capacity to compete and deliver on megadeals. However, many of these new entrants don’t understand the complexities and intricacies involved in satisfying enterprise requirements, which could lead to service disruptions and other continuity issues.” (Russ Daniels, Chief Technology Officer, HP Enterprise Services) “The risk in taking the best-in-class route and selecting multiple providers is that some providers would end up with an incomplete view of and alignment to the buyer’s strategic objectives.” (Abid Ali Neemuchwala, Global Head, TCS BPO Services) “While a multi-provider approach can potentially lower costs, it adds significant complexity in compatibility of technologies and handling of many contracts (which would be shorter term and renewed more often).” (Charlie Bess, HP Fellow, HP Enterprise Services) Risk #3 – Building the business case “Building a proper business case is a buyer’s most important step to capture the value it wants to drive and the scope and cost of the services. A half-baked business case will lead to value erosion and post-purchases price adjustments, which will then lead to dissatisfaction.” (Rajan Kohli, CMO, Wipro Technologies) “A lot of challenging deals have resulted from a business case with an extreme emphasis on cost. The focus should be on evaluating how cost of services impacts quality, value, relationship viability, scalability, sustainability of business value, and innovation – not just how it impacts the bottom line. In the current business environment, it is imperative that buyers make sourcing decisions based on a solid business case that includes increasing agility over the long term.” (Deepak Patel,CEO, Aditya Birla Minacs) Risk #4 – Underestimating the complexity of managing a “hybrid” environment “Managing a “hybrid” IT environment (which includes a mixture of in-house, shared, outsourced, and cloud services) demands new models for service level agreements, end-to-end operational accountability, service management, enterprise architecture, and IT portfolio management. Buyers will have to establish a new IT governance structure and develop a multi-year transformation road map.” (James Miller, HP Fellow, HP Enterprise Services) Risk #5 – Disruptive technologies “The proliferation and enhanced capability of mobile devices will present security, asset management, application, and end-user support challenges. Buyers must address these challenges in their IT outsourcing decisions.” (Kevin Schatzle, President, Allied Digital Services) “Disruptive technologies such as cloud and mobility offer opportunities for business model transformation. Buyers will have to choose providers they trust to be independent in their advice and work with them to achieve the objectives they set. Since these technologies carry an element of risk, buyers will prefer a model that enables business outcome.” (Rajan Kohli, CMO, Wipro Technologies) “Security considerations are crucial in considering cloud-delivered solutions. Buyers need to ensure their providers follow the ITIL process and approach all outsourcing business with an eye towards security. In addition, buyers should keep in mind over the next few years that service providers can easily provision cloud-based delivery of services in a pilot as a proof of concept.” (Kevin Schatzle, President, Allied Digital Services) (Also see Assessing the Coming Impact of Cloud Computing on Outsourced Solutions.) Risk #6 – Governance mistakes “Change management is a crucial element of outsourcing relationship governance. The key issue to tackle in change management is to set detailed guidelines on when a change has a financial impact on the deal, allowing the provider to charge additional fees or the customer to pay fewer fees. Failing to have effective change management methods often leads to protracted discussions (and most likely differences of opinion) as to whether any given change impacts the financials. These discussions will delay or possibly inhibit an implementation.” (Rajan Kohli, CMO, Wipro Technologies) “The biggest mistake buyers currently make …

"*" indicates required fields

Start your outsourcing journey.

Book a call with an outsourcing expert now

This field is for validation purposes and should be left unchanged.

"*" indicates required fields

This guide will walk you through some areas most important when outsourcing, such as
  • Identifying Your Outsourcing Needs Intelligently
  • Research & Selection
  • The Bidding Process
  • Contracts & Agreements
  • Implementation & Onboarding
  • Ongoing Management
  • Evaluating Success
  • Additional Resources

Book a call with an outsourcing expert now

This field is for validation purposes and should be left unchanged.

"*" indicates required fields

Become an OC Partner
This field is for validation purposes and should be left unchanged.

"*" indicates required fields

Media Inquiries for OC
This field is for validation purposes and should be left unchanged.

"*" indicates required fields

Subscribe to our Newsletter
This field is for validation purposes and should be left unchanged.

"*" indicates required fields

Submit Press Release
Accepted file types: pdf, doc, docx, Max. file size: 8 MB.
This field is for validation purposes and should be left unchanged.

"*" indicates required fields

Submit an Article
Accepted file types: pdf, doc, docx, Max. file size: 8 MB.
This field is for validation purposes and should be left unchanged.

"*" indicates required fields

Request Ben Trowbridge as a Keynote Speaker
This field is for validation purposes and should be left unchanged.

Go to standard quote

Exclusive Enterprise Assistance

  • Independent
  • Trusted
  • Transparent

Offshore staffing solutions for enterprise. Independent expertise, advice & implementation

  • 200+ Firms, Global Reach
  • Offshore, Nearshore, Onshore, Rightshore
  • Managed Request for Proposal (RFP)
  • Assisted Procurement Processes
  • Vendor Management
  • Unique Build Operate Transfer model
  • Captive & Shared Services
  • Champion-Challenger
  • Multi-site, multi-vendor, multi-source
  • Managed Solutions

For Enterprise and large teams only

  • Book 20-minute consult, obligation free

You will get:

  • Needs Analysis & Report
  • Salary Guidance & Indicative Pricing
  • Process Map

Only takes 1 minute to complete the form

Get Started

Not an enterprise?

Go to standard quote