By Jeffrey B. Andrews, Thompson & Knight LLP
Why is outsourcing such an effective strategic tool? Quite simply, outsourcing provides companies with a proven means to increase their profitability.
Yet just as with any long-term service relationship, problems are inevitable. Disagreements over the scope of the services, static pricing that fails to remain competitive, and the service provider’s failure to deliver promised innovation and performance improvements can lead to increased costs that erode the profitability gains achievable through outsourcing. To address these problems, customers should include provisions in their contracts that comprehensively define the scope of the outsourced services, provide for service evolution and continuous improvement, and provide for pricing resets tied to changes in market prices.
Carefully Define the Scope of the Outsourced Services:
One typical friction point in outsourcing relationships is determining when work constitutes services that are contracted for within a defined scope versus when work constitutes new services for which additional charges apply. A root cause of this issue is the contractual definition of the outsourced services. http://www.tklaw.com/ Yet since the contractual definition of the outsourced services establishes a baseline for determining when work constitutes a new service, it must be comprehensive. Otherwise, the customer risks the service provider refusing to perform work that the customer intended to outsource unless the customer agrees to pay additional charges.
To avoid this problem, the contractual definition of the outsourced services should be drafted by referencing functions and responsibilities that are not specifically described in the contract. For instance, the in-scope services should include functions and responsibilities being performed prior to the execution of the contract by the employees or contractors of the customer.
This definition should include those functions or responsibilities that may be eliminated or displaced as a result of the contract. The in-scope services should also include functions and responsibilities not specifically described in the contract, but which are an inherent or necessary part of the in-scope services.
By referencing such functions and responsibilities, all of the services the customer intended to outsource are covered by a comprehensive definition and must be performed as part of the in-scope services and for the charges set forth in the contract.
Expressly Provide for Service Evolution and Continuous Improvement:
The integrations clause of a contract will exclude any terms not set forth within its four corners. Consequently, promised improvements to and evolution of the outsourced services (such as upgrades to processes and technology) contained in the service provider’s marketing materials and proposals must be translated into contractual obligations to ensure their delivery. If the customer fails to include such provisions in the contract, the customer risks having to pay extra for such improvements as new services.
In addition, if the services are not improved or do not evolve to keep pace with market developments, the customer also risks incurring unanticipated costs to maintain the retained aspects of its operations that interact with or depend on outsourced functions (such as costs related to technology for which maintenance is no longer commercially available). In each case, such expenses eat away at the cost savings the customer hoped to achieve through outsourcing.
To avoid these problems, customers should include provisions in their contracts that commit the service provider to implementing an attached description of the solution proposed during the sales cycle, or at least incrementally improving the outsourced services to keep pace with technological advances and the customer’s business needs.
Such provisions provide the customer with assurance that the manner in which the services are performed and the resources used to perform the services will evolve over the life of the contract. Such provisions should also expressly provide that the activities needed to implement such solution and affect such evolution are not new services. Thus such activities shall be part of the in-scope services and shall be performed at the contracted-for charges.
Pricing Resets Tied to Changes in Market Prices:
One primary way a customer realizes cost savings is through competitive pricing. In long-term outsourcing arrangements, pricing that was competitive when the customer executes its contract may not be competitive a few years afterwards. To avoid this problem, customers should include benchmarking provisions in their contracts. Benchmarking rights give customers the ability to compare the charges payable under their contracts to prevailing market prices for similar services, and align their charges with market prices.
If the charges payable by the customer are higher than prevailing market prices for similar services, then many benchmarking provisions require either a renegotiation or resetting of the charges to eliminate any unfavorable variance. While benchmarking rights are typically heavily negotiated, the prospect of intense negotiations should not dissuade customers from insisting on this invaluable tool to ensure that their pricing remains competitive.
To realize the profitability gains achievable through outsourcing, great care must be taken in structuring the outsourcing contract. By including provisions that carefully define the scope of the outsourced services, expressly provide for service evolution, and provide for pricing resets tied to changes in market prices, outsourcing customers can mitigate or avoid a number of typical problems in outsourcing arrangements that lead to increased costs and erode the profitability gains achievable through outsourcing.
Jeff Andrews, a Partner in the Houston office of Thompson & Knight LLP, focuses his practice on structuring and negotiating domestic and international information technology and business process outsourcing transactions across a wide range of industries. He can be reached at 713-951-5890 or firstname.lastname@example.org.