5 “Gotchas” When Negotiating an Outsourcing Agreement | Article

Negotiating a good outsourcing agreement involves much more than just achieving the pricing you desire.  As you go through the process, you will go through the normal “give and take” discussions as you work with your potential provider(s).  However, it is important that you do not focus solely on pricing.  While reducing cost is typically the primary value proposition for outsourcing, you also want an outsourcing agreement that allows you to realize your immediate and long-term delivery needs, provides contract flexibility and ensures that you receive maximum value for the money you will be spending.  To meet those objectives, pay careful attention to the five “gotchas” noted below.  These areas of the agreement, if not carefully structured, can drain value from your business case and decrease the probability of having a successful and sustainable outsourcing agreement.

1) Statement of Work – A Statement of Work (SOW), when created correctly, describes in great detail (typically 100+ pages for a full information technology outsourcing agreement) the services to be performed by the provider and also clarifies certain client responsibilities. The SOW describes WHAT will be done for the price.  A few check-marks in the wrong responsibility column or a handful of missing tasks can significantly change the amount of service the provider is to deliver and will result in misaligned expectations from the start of the contract.  Because the SOW is the “meat” of what the provider will do for you, you need to ensure it fully describes the services you expect from the provider.

2) Service Levels – Service levels work in conjunction with the SOW to scope the services that the provider will deliver.  They describe HOW MUCH and TO WHAT EXTENT the services described in the SOW are delivered.  Service levels and assumed labor costs are two primary drivers in a provider’s cost model.  It is important that the service levels reflect what you need even as you are negotiating price.  Importantly, you should realize that the costs go up exponentially as you get closer to a 100% performance target.  Outside consultants with market information can help you determine a fair price for the service levels you require.  Additionally, there are important service level terms that should be included to allow you the freedom to add and change service levels and to re-allocate service level credits as your business needs change.

3) Termination Language – It can be hard to focus on termination language and termination charges at the beginning of an outsourcing relationship.  Termination language is analogous to a prenuptial agreement – it is there “just in case” things do not work out as originally intended.   As the final negotiations occur, you may be tempted to give a bit on the termination language in order to get to the price point you want.  Depending on your starting point, some “give” might be acceptable but you first need to understand the ramifications if you need or want to get out of the agreement (or pieces of the agreement) in the future.  Once the contract is signed, it can be especially difficult and costly to get out of it if the termination language is favorable to the provider.

4) Future Pricing – There are a number of factors to consider regarding future pricing.  On the whole, you should expect your IT costs to go down over time due to improvements in hardware and software functionality and pricing, labor arbitrage, automation, and so forth.  Because each situation is different, there are no easy “rules of thumb” to apply, but pay close attention to these specific areas:

  • Year-over-Year Pricing – You should expect the unit pricing for most towers (possibly excluding applications due to its labor-centric nature) to go down each year, with the provider accepting the risk of continuously improving and streamlining its operations to achieve lower price points each year.
  • Cost of Living Allowance (COLA) – From your perspective, it would be ideal to not have a COLA, but the reality is that many providers will require it to give some risk protection in the out years.  Any sort of cost of living increases should be tied to a well-known government index.  Each tower should have a “COLA index” that indicates the portion of the unit pricing that can be affected by a COLA index.  They should be country-specific if you will be receiving labor from an offshore location, and they should be capped to reduce your risk.
  • Variance Pricing – Many outsourcing contracts contain variance pricing based on resource usage.  An assumed number of resources are built into the annual price, and then adjustments are made up or down based on actual monthly usage.  The concept is simple, but you need to watch for how that will work for you based on your future growth assumptions.  For example, if a provider expects that your business will grow over time, they may propose a lower base price to meet your initial price point, but then have a relatively high additional resource charge, or ARC rate, for additional volume.

5) Delivery Locations – In return for hitting your price point, a provider may want to include the freedom to deliver from whatever location they see fit.  There are many risks associated with movement of work from one team to another, much less from one country to another.  Because of the potential impact to your business, you want to make certain that you have some sort of approval authority prior to the movement of support functions.  The provider may counter that they are accepting the risk because they are signing up for service levels.  However, the potential business impact to you is much greater than their risk of incurring service level credits for missing a couple of metrics.

In summary, these five potential “gotchas” need to be managed closely through the negotiation process.  Due to the variations and complexity inherent in each deal you should strongly consider the use of an outside outsourcing advisor to help.  Because they understand your perspective as well as the providers’ point of view, they are ideally positioned to help manage through these items (as well as the many other items that will arise) and develop an outsourcing agreement that works well for both you and the provider.

1 Comment on "5 “Gotchas” When Negotiating an Outsourcing Agreement | Article"

Trackback | Comments RSS Feed

Post a Comment