Outsourcing: Negotiating a perfect fit

Get the contract right and you are more than halfway towards an efficient and profitable outsourcing partnership

A clear, fair and well-negotiated contract provides the basis for an effective and happy long-term outsourcing partnership. The key elements of the contract address service-level agreements, penalties and rewards, timeframes and measurements, regular reviews, and exit strategies.

It is essential to reach a clear definition of the scope of the outsourced operations beforehand. The contract should define the full extent of the services that are to be delivered and for which the service provider will be responsible - including the levels to which services must be delivered. Ideally, this should be based on detailed schedules so that neither side can be in any doubt over what is required of the service provider.

Setting these service levels so that both parties can benefit is fundamental to business process outsourcing contracts, says Michael Hyltoft, senior consultant with independent outsourcing consultancy Quantum Plus. "These identify the service deliverables and expectations of your service provider," he says. "Good contracts will also describe the reporting methods for service-level measurement, how, when, and the level of attainment required. This will include potential penalties or benefits."

When determining service levels, companies should make sure these apply to matters that are critical to the business, because each service level will have a cost attached to it, and too many checks can make the service regime onerous for the supplier.

Richard Peynot, senior analyst at Forrester Research, says, "Service-level definition causes most challenges. Companies have checklists that set out their basic service expectations, but these are generally incomplete. Users' negotiating teams struggle most with putting SLAs in legal terms."

Gillian Cameron, partner at corporate law firm Maclay Murray & Spens, says, "The key thing with service levels is clarity. It can be very difficult if you have a large complex system and different levels of service may apply to all of them. Simplicity is a challenge in that context. If the agreement is too obtuse, everyone loses out."

She says objectivity is also important in ensuring the service level measurements are fair for both parties. "Try to make it objective, so there can't be any argument about the service levels, and also be clear as to what you are measuring, for example, is it a response time or a fix time?" says Cameron.

Companies should also be prepared to define processes and time periods for performance measurement. "Once you have got to the core of what people are measuring, it is all about writing it down properly," says Cameron. She says technology can be very helpful in measuring performance and time periods, and the metrics used by an agreed technology can be written into the outsourcing contract.

Cameron points out that the issue of software licensing is also worth covering in the contract, because an external provider typically takes over the running of core software, taking out ongoing licences in the customer's name. In such cases, it is worth determining whether the licence stays with the client after contract termination, and what exactly is permitted by the licences themselves.

It may be beneficial to agree beforehand a set of penalties or incentives for poor or excellent performance. With new relationships, this can help to develop trust between the business and its outsourcing supplier, and help to give the supplier incentives for good performance.

The most common forms of penalty are service credits and "liquidated damages". The former tend to involve small sums of money deducted from the service charges when services fail to comply with the agreed levels. Liquidated damages are monetary compensation specified in the contract for breach by one of the parties and are calculated in relation to the customer's estimated potential loss.

In terms of rewards, benefit sharing is often used to reward the service provider for delivering real business value to the customer. Percentage uplift is another term used to describe a clearly defined improvement on a service benchmark, for which there can be a financial reward.

David Isaac, a partner at law firm Pinsent Masons, says most of the contracts he sees have penalties and incentives written into them for service levels and performance. But he adds, "You should move away from trying to get service levels for everything, because they are expensive to set up and police. You need a sensible regime for the supplier."

As the relationship between the two parties matures, with more trust and understanding of business objectives, you need to get away from the carrot-and-stick approach, says Isaac.

According to Forrester, clients often expect to transfer too much liability and risk to the supplier, and the limits of liability often cause disputes. "As our discussions with external outsourcing advisers confirm, client companies frequently set unduly high limits for compensation in case of production losses - some even demanding up to two or three times the revenue amount lost. No experienced vendor will accept this," says Peynot.

Companies looking to outsource should aim to agree on possible opportunities for reshaping or refocusing operations mid-term. It is worth building a review mechanism into the contract, so that reviews are carried out periodically with a view to making changes. "You need a mechanism for carrying out health checks, and governance meetings, with a two-way exchange about things that are changing - often the management on the customer side is n0t as good as it could be," says Isaac.

According to Pinsent Masons, roughly 70% of all outsourcing deals are renegotiated within two years of the contract being signed. Reasons for this include pricing, business change and service performance.

In such cases, both parties should be clear about the purpose of any review, and it must not be used as an excuse for one party to get out of the agreement at an early stage, or to lever a better deal. "If you are going to change the contract, it must be on an agreed basis," says Cameron.

Isaac says, "In some cases, the supplier is rewarded for over-performance - it can be good, but actually is not necessarily driving the right behaviours. If you want them to behave as though they were you, see where you can incentivise the supplier to come up with innovative ideas and demonstrate significant savings; then they should be rewarded for that, but you cannot particularise."

He mentions a high-profile "third-generation" outsourcing deal in the engineering sector, where the company has been outsourcing with the same supplier for many years. It now deals with the supplier as if it is part of the organisation. "They are very mature in the way they deal with things, and the supplier is making a large investment in the client. They are a very good example," adds Isaac.

Finally, negotiating termination or exit strategies, and having options for continuation after the end of term can make or break an outsourcing deal.

"An important issue often missed from the contract is the termination or exit strategy," says Hyltoft. "Legally, both parties should have an agreement on how to terminate the contract at any point. Be aware that in contrast to traditional IT, outsourcing BPO service level agreements are business-based, not IT-based. Therefore, you will need to focus on handling processes, business outcomes and people."

Peynot says, "Termination conditions cause frequent disagreements. For example, the details of the transition phase at the end of a contract are tricky. The incumbent is supposed to assist the new provider, but questions arise about the handover period, when it should happen, the duration, and the fees. Firms we spoke with at least try to soften the conditions around early termination, or even avoid them altogether, rather than accept the exit period and compensation that most vendors seek."

Cameron says there are several standard conditions that would justify termination of a contract, including a general breach of agreement, and insolvency. She says, "In addition, something unforeseen may happen - for example, if the company becomes acquired and managed by its competitor."

In such cases, the contract needs to specify the terms of any handover of outsourced business process obligations, either to an in-house team or to another service provider.

Companies should examine whether they need to have the ability to achieve a partial termination of the contract, says Isaac. As an example, he refers to a global outsourcing contract where the company got into financial difficulty and decided to dispose of a number of its businesses, which had an impact on the outsourcing deal.

"If you are having those discussions, the supplier is looking to be made whole, to recover its stranded or sunk costs. The difficulty is then agreeing what the payment should be."

Contract checklist

* Service-level agreements
* Time frames and measurements
* Penalties for under-performance
* Rewards and incentives
* Regular performance reviews
* Scope to renegotiate and revise
* Termination clauses.



Think ahead for successful negotiation

In preparing to approach the negotiating table with the outsourcing provider, it is worth carrying out an initial investigation to understand your organisation's particular objectives and needs, says Dalim Basu, director at BPOinform, a centre for IT and business process information.

Secondly, carry out a thorough risk assessment. Basu says, "This might involve consideration of some of the traditional objections to outsourcing. These include the risk that suppliers may not understand your organisation's unique IT and business processes or that you may never be able to take the work back in-house and the quality of service may decline over time."

He adds that companies should develop a strategic roadmap showing how to achieve objectives and identifying the potential risks as well as expected benefits.

Thirdly, when approaching the contract negotiation, have a well thought-out negotiation process, advises Forrester Research.

"Some companies, surveyed by Forrester, expressed difficulties in negotiating the outsourcing contract. One finance firm says, "Negotiating was a hard job, because of the repeated iterations and the time waiting for the vendor's answers. We were disappointed in that, because we expected to be able to discuss the proposals in half the time we actually needed."

A chemical company says, "Big providers have typical big-company attitudes. They have a price list but they don't tell you what it is. They just look at how much you can afford."

And an insurer says, "I have one simple principle: if I can't understand where the price comes from, and they can't explain why I have to close the deal for that price, then there will be no close."

Richard Peynot, senior analyst at Forrester Research, says, "Negotiations drag on longer than buyers expect. Almost every firm struggles with outsourcing negotiations and finds them more time-consuming than expected."

He adds that many European companies are approaching their first or second IT outsourcing project, or are currently in renewal discussions. "Most of these firms tend to underestimate the necessity of a stable negotiation process and the importance of involving the right competent people during contract discussions. As a result, they commonly miss important points in contracts, leading to vendor management issues later on."

Peynot adds, "Serious misunderstandings and divergence of interest between users and outsourcing vendors frequently appear, even during the contract negotiations themselves. Forrester's recommended best practices define a structured process that underpins all aspects of the negotiation."