Negotiating Effective Service Level Agreements (SLAs) | Article

SLAs are now part of outsourcing’s alphabet soup. In recent years, outsourcing consultants and lawyers have heavily emphasized the importance of including SLAs in contracts. That trend comes from experience gained when many customers learned that they had little ability to influence the outsourcer’s performance without an SLA.

Although SLAs are included in rudimentary “best practices,” many customers still fail to negotiate an effective SLA that will provide value in the outsourcing relationship. An overview of effective SLAs and some of the challenges in negotiating these agreements helps explain why.

What Are SLAs?

In the context of outsourcing, “SLAs” simply identify certain service levels or performance standards that the outsourcer must meet or exceed. The SLA also specifies the consequences for failure to achieve one or more service levels, such as credits granted to the customer on future invoices or rights of termination on behalf of the customer in certain instances. The SLA may also include credits or bonus incentives for performance that exceeds targets.

Although in industry practice the SLA is a separate addendum to the outsourcing contract, it is not legally a separate agreement, but another set of terms and conditions of the outsourcing contract itself.

Structure of SLAs: Good, Bad, and Ugly

A good SLA will usually include a section that provides precise definitions of key terms. Next, specific service levels will be described in perhaps more than a dozen categories. For example, if data center functions are outsourced, service levels could include host CPU availability, CPU response times, batch job completion, help desk responsiveness, security administration, problem management and change management service levels. If other functions are outsourced, such as desktop or network services, they must be defined also. In most cases, service level compliance is measured on a monthly basis.

From such service levels, the parties identify certain “key” service levels. It could be that the host CPU availability is a key service level in addition to certain response time and batch processing measures. Key service levels will be weighted by importance or severity so they total 100 percent. Then, if the outsourcer fails to achieve some of the key service levels, the percentage of key service levels missed for the month can be applied as a service level credit against a percentage of the invoice. If all the key service levels were missed in that month, then the full percentage service level credit could be given to the customer.

In some cases, the parties may choose to identify not only a threshold level of acceptable performance for each service level, but also a level of “increased impact” if the performance is at an agreed level below the threshold service level. If the outsourcer’s performance falls below the increased impact level, the percentage service credit may increase substantially.

Another factor that may be included in calculating service credits is a “frequency factor” that measures the number of times a particular service level is missed during an interval, such as a rolling 12-month period. If the frequency factor is triggered, the percentage to be applied against the total service credit is increased by some factor, for example, 1.5 or 2.0.

Just because certain service levels are not included in the “key service levels” does not mean they have no significance. First, they provide an objective measurement for tracking performance in areas that are important to the customer’s business and can spotlight the problem areas. Second, these non-key service levels are in fact contractual obligations which if not met, could form the basis of a claim of breach of contract by the customer.

Critical Conditions

Often the parties identify a subset of the key service levels as critical. For these critical service levels the parties will agree that the outsourcing contract may be terminated by the customer if the outsourcer fails to meet them at the frequency specified. Why is it important to include this type of provision? Contract law generally entitles one party to terminate a contract if the other party “materially breaches” the contract. A breach that isn’t “material” may entitle one party to claim damages, but it will not entitle that party to terminate the contract. Identifying the “critical” service levels and providing specific conditions for termination eliminates ambiguity in determining whether circumstances entitle the termination of a contract for cause as a material breach.

Prospective outsourcing customers often are curious about industry standards for the range of service credits in outsourcing SLAs. If there are such standards, they are difficult to identify, but it is not unusual to see potential service credits ranging from 5 to 10 percent of a monthly invoice for routine service level failures and up to 15 to 20 percent of a monthly invoice for more severe or frequent failures. A severe penalty for service level failure could actually worsen the service problem if it results in the outsourcer making no profit during a prolonged period.

Carrots and Sticks

Two special issues that deserve extra attention are the performance bonuses for the outsourcer and negotiation of the force majeure clause.

An issue that can have a significant impact on both parties is the inclusion of “performance bonuses” if the outsourcer exceeds the service levels specified in the SLA. While the customer is entitled to credits for unsatisfactory performance, the outsourcer may be entitled to bonuses for performance that exceeds the service levels. In typical IT outsourcing, customers expect the outsourcer to exceed the service levels without special compensation.

The view of service levels as minimum standards means they are not considered the target optimum performance standards. If the outsourcer can add real value to the customer’s business, customers should be willing to share the value gained as a result of superior performance. Some customers are willing to include performance bonuses in the SLA if structured to provide real incentives for outstanding performance by the outsourcer. For example, any bonuses that are earned by the outsourcer might be earmarked for a bonus pool for key team members.

Force majeure clauses excuse a party’s failure to perform if the failure resulted from an act of nature such as an earthquake or other natural disaster beyond the party’s control. In outsourcing contracts, negotiating the provisions of excused performance in the context of the outsourcer’s responsibilities and liabilities can be most challenging and time-consuming.

Examples include failures resulting from the customer’s non-performance, failures of third parties, and failures in hardware and software. Outsourcers seek a broad definition of force majeure and customers seek a narrow, tightly defined provision. Fair resolution lies somewhere in the middle. In any event, provisions should be included in the SLA addressing the outsourcer’s responsibility to correct and mitigate the effects of an excused performance failure. A force majeure event should not completely absolve the outsourcer from any responsibilities whatsoever.

Negotiation Challenges

Customers negotiating outsourcing contracts for the first time may be surprised to find that outsourcers are generally not proactive in proposing a fair and well designed SLA structure to the customer. Unfortunately, outsourcers may respond to a proposed SLA from the customer and negotiate in hopes that the customer will ultimately agree to an SLA that favors the outsourcer. There is clearly an opportunity for progressive outsourcers to distinguish their services by drawing on their experience in drafting and implementing an SLA structure that thoroughly addresses the customer’s needs in a fair manner.

Every customer must be prepared to know what they want and why they need theSLA, and be ready to convince the outsourcer. Reasonable customers will avoid over-measuring and including every imaginable service level. They should agree to fair credits for failures in meeting the service levels. Outsourcers should be willing to understand that the customer requires significant protection in the SLA, and acknowledge that there are certain levels of performance that would justify termination of the contract.

SLAs are not easy to design or negotiate. But a comprehensive, fair and effective SLA is critical for a successful outsourcing relationship. In the course of negotiating an SLA, customers and outsourcers have the opportunity to learn a lot about how their future partner will approach important issues in the outsourcing relationship.

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  1. Excellent written about SLA, I really appreciate the working of author of this artical.

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