Linking Service Descriptions to the Economic Model
It is trite to say that in any outsourcing transaction, the service description is critical to the deal. The services are, after all, the essence of the outsourcing regardless of the impetus for doing the outsourcing in the first place (such as cost reduction, technology improvement, business transformation, and so on). The service descriptions are used to establish the framework for the economic model and the base fees that will have to be paid by the business owner. These service descriptions are key for establishing what the service provider must do for the base fees and can be critical to determining the scope of what’s in and what’s out. Anything that is out of scope is likely an “extra” both in terms of the services to be provided and fees to be paid. As a result, it is critical that the parties have a mutual understanding of how the service descriptions will work with the economic model, what is included in the base fees, and when the service provider can charge for the so called “extras”. This is where the service descriptions can be tricky, and where their alignment to the economic model should be clearly understood and agreed to by both parties to the outsourcing.
How the services are described, and how they are linked into the economic model, can be germane to the success of the outsourcing. While this may seem like a basic principle for any outsourcing, it can be difficult to put into practice and is often the topic of great debate between business owners and service providers after the contract is signed.
Activity & Function Based Service Descriptions
Many service descriptions are articulated as inputs to the outsourcing, appearing as a long list of functions and activities that must be undertaken by the service provider, which are described with various levels of detail. This method of describing the services has its pros and cons for both parties, but for different reasons.
For the business owner, there is a certain appeal because it provides a high level of certainty regarding the nature of the services being provided, and perhaps a stronger feeling of control over the business being outsourced. The importance of this sense of control should not be underestimated, particularly at the beginning of the relationship before any trust is established between the parties. That said, there are downsides to this prescriptive manner of describing the services. First, if an activity or function is missed in the service description (and there will usually be a few of these), then it may be viewed as an “extra” by the service provider, warranting an additional charge over and above the base fees. This is typically addressed by the inclusion of language to the effect that functions and activities not specifically indentified which are incidental to the delivery of the services are necessarily included. Unfortunately, this will only provide so much protection to the business owner, as there will invariably be a point where the parties disagree on the unspecified functions and activities that are incidental to the performance of the services. It may also come down to whether or not these unspecified functions and activities were actually costed into the economic model by the service provider.
This approach to the prescriptive description of the services is often tied to a transactional based or cost-plus economic model, where the business owner assumes most of the pricing risk (as fees are typically based upon the transactions, activities and functions performed, instead of their efficiencies and outcomes). For some outsourcings, this may be preferable depending upon the nature of the outsourced business, but for others, it could hamper the realization of the outsourcing’s objectives.
For the service provider, this prescriptive form of service description may clarify what is in and what is out of the base fees, but it can also border on telling the service provider exactly how to perform the services (this comes as a by-product of the detailed description of the functions and activities that comprise the services). Service providers are often asked to do more with less, and their ability to do so can be seriously hampered if they are being told “how” to deliver the services, as opposed to “what” to deliver. The detailed articulation of activities and functions can also be used by business owners to micro-manage service providers. This can be disastrous to both the outsourcing and the relationship of the parties.
If the outsourcing includes any business transformation (which would be typical for most outsourcings), then the prescriptive manner of describing the services may result in unintended consequences. For example, as the business transformation is implemented, the service description will quickly becomes obsolete. Depending upon how the services are linked to the economic model and the fees to be paid, the parties could end-up in a fee dispute with one party wanting a fee reduction for specific activities and functions no longer being performed, and the other wanting a fee increase for the transformed service delivery not contemplated in the service description. The prescriptive approach to describing the services could also interfere with the service provider’s ability to transform the business, or realize the savings necessary to enable the service provider to do more with less. Hard-wiring the detailed activities and functions in the service description can also force the service provider to provide the services the same way that they were done before, jeopardizing some of the goals and objectives of the outsourcing, and making it difficult for the deal to realize its potential. This could ultimately become problematic for both parties and may lead to a renegotiation of large portions of the outsourcing early on (which is not uncommon to see in the first 18 to 24 months of an outsourcing deal).
This prescriptive approach to describing the services does not always accommodate business transformation. Whatever the activity or functions, and however they are described, chances are that they will be fundamentally different a few years after signing the deal if business transformation is included as part of the outsourcing. Even if business transformation is not specifically contemplated, use of technology advancements in the ordinary course of business will likely result in some of the service activities and functions becoming obsolete over time. How these changes will be accommodated in the service description and the economic model should be discussed at the outset and well understood by both parties.
At the other extreme is the pure outcomes-based approach to describing the services to be performed in the outsourcing. The theory behind an outcomes based approach is that the service provider must deliver the outcome or business result, in whatever manner the service provider determines. This approach requires a clear articulation of the outcomes that the service provider is to achieve. While theoretically attractive, this approach is easier said than done. To be effective, the outcomes must align with the objectives of the business owner, be measurable, achievable, and within the sphere of control or influence of the service provider. The outcomes-based approach does not specify the ‘how”, but goes straight to the end-result, it focuses on the “what”. The outcomes themselves must be sufficient to support the service delivery requirements of the business owner. In addition, the business owner must be comfortable relying upon just the outcome itself, and for that reason, defining the outcomes can also be challenge.
The outcomes-based approach requires a tremendous amount of trust in the service provider, and a significant letting go by the business owner. This “letting go” can be difficult for business owners as the outcomes-based approach often lacks transparency into how the services are being performed. The level of trust required between the parties for an outcomes-based approach to succeed develops over time, as the parties work closely together, but it is rarely there at the outset of an outsourcing deal.
The outcomes-based approach to describing services represents a shift of risk from the business owner to the service provider who is essentially delivering on results, or outcomes, as opposed to merely performing specified functions and activities. This can be attractive to service providers as it affords them the flexibility to determine the method and manner in which the services will be delivered, and can work to both parties advantage as long as the service provider is able to control the outcomes. The outcomes-based approach may come at a premium given the shift of risk from the business owner to the service provider. However, if the agreed outcomes are delivered, then the premiums paid for the services should be more than off-set by the value of the delivered outcomes to the business owner.
Moving to a true outcomes-based approach to outsourcing is difficult to do in practice. As a result, there is sometimes a tendency to adopt a hybrid model that combines elements of the outcomes-based approach with the detailed and prescriptive service delivery descriptions. The hybrid approach may also use outcomes for only specified portions of the outsourcing, and detailed service descriptions for others. The hybrid approach can be effective as long as it is appropriately tied to the economic model in a way that will incent the appropriate behaviour by both parties, and provide some measure of certainty as to what is in and what is out of the base fees.
Whatever method is used for describing the services, whether it is a detailed activity and function based approach, an outcomes-based approach, or a combination of the two, it is critical that the service description be appropriately tied to the economic model. The potential scope of the “extras” should be clearly understood and agreed to by both parties. The manner of service delivery change during the life of the deal, and any resulting fee changes, should also be contemplated and agreed to in advance, and accommodated in both the service description and the economic model.