In the previous post, I looked at a Gartner Group survey, which found that one of the biggest issues resulting in contracts being prematurely renegotiated was that they lacked the flexibility to handle unforeseen changes. This is the second in a series of posts examining some of the ways in which outsourcing agreements can be structured to accommodate change over the life of the contract. In my last article, I looked at contractual mechanisms designed to accommodate unanticipated M&A activity. In this article, I look at mechanisms designed to address the financial responsibility for future changes.
(i) Allocating Financial Responsibility in Advance
Over the course of an outsourcing agreement, required changes may affect the delivery of services under the outsourcing contract or either party’s related costs. Since these changes can result in additional or decreased costs, the time spent on deciding which party should bear those costs or benefit from a cost reduction can delay the timely implementation of required changes. It is in the best interests of both parties to avoid this problem, which can be accomplished by addressing the allocation of financial responsibility for such changes upfront, at the time the contract is entered into. The typical stumbling block in resolving this point is that the parties do not know the exact nature of these changes in advance. However, a way forward can be found if they anticipate and account for financial responsibility according to certain categories of potential changes.
(ii) Determining Financial Responsibility According to Categories
Broadly speaking, there are two categories that should be considered: (a) changes that will be implemented by the vendor for no charge; and (b) changes that will be implemented by the vendor for a charge. The agreement should cover both kinds.
While every transaction is different, there are many examples of changes that typically fall within the first category. For instance, changes that must be made in order for a vendor to comply with applicable law may be borne by the vendor without charge to the customer, and accordingly would fall within the first category. The parties may identify other examples applicable to this category. For the reasons referred to above, it is a best practice for the agreement to include the allocation of financial responsibility for this category.
The second category can, in turn, be divided into two subcategories: (a) changes that affect the particular customer as well as other customers of the vendor; and (b) changes that affect only that customer.
In the first subcategory, if there are changes that are required by some but not all of the vendor’s customers and that do not fit within the category of changes that the vendor is required to implement without charge to the customer, one way of allocating financial responsibility would be for the customer to be responsible for the charge, but on a pro rata basis. The logical point being addressed in this instance is that the vendor will be required to make the change for each customer affected, but should not charge each one individually the full cost of implementing the change. Instead, it is divided equally between all such customers. The existence of this subcategory, and its relevance to any particular outsourcing, assumes that the vendor’s infrastructure used to deliver the services to the customer is being shared and used for other customers.
Finally, the second subcategory functions as a basket that catches every other kind of change. These are changes required by the customer that do not fall into either of the two preceding categories, and the financial responsibility for which should be fully borne by the customer.
By accounting for changes in this way ahead of time, a long-term outsourcing agreement can accommodate changes through embedded contractual terms that are designed to provide flexibility and financial predictability, even if the particular changes themselves can’t be foreseen.