Long Term Outsourcing Relationships – Price Adjustment Provisions

My last column focussed on customer and service provider concerns that arise with various aspects of long term outsourcing relationships. I now want to discuss structuring specific provisions to take those concerns into account. This week’s posting will look at price adjustment provisions and the one to follow will discuss change management.

The price adjustment provisions of long term outsourcing arrangements need to respond to the concerns of the customer and the service provider. For the customer, these concerns are based on the worry that, after a few years, the customer will be paying too much for its outsourcing services: perhaps because of the cumulative impact of year-over-year declines in market price, after a few years the pricing of the services it is purchasing will be uncompetitive. The service provider, on the other hand, is concerned that any price adjustment provisions that are designed to ensure the customer receives market competitive pricing will skew the pricing, eliminating deliberate back-end loading or the intentional cross-subsidization of low margin services by the higher margin ones. In either case, the impact of any price adjustment provisions will be to erode the service provider’s profit margins or, in extreme cases, force the service provider to provide services at a loss.

In designing the price adjustment provisions that will respond to these concerns, the customer and the service provider should consider:

(i) how the pricing is structured under the outsourcing relationship;

(ii) the information that will inform their decisions; and

(iii) the price adjustment process.

The Pricing Structure

For the price adjustment provisions to be successful, the customer and the service provider must have a clear picture of both the services being provided and the prices being charged for those services. In a recent ten year transaction, the monthly price for services was flat lined over the entire ten year term, with the customer paying the same aggregate fee each month of the term for all of the services it received. This meant that, on a daily basis, the customer and the service provider did not have a good sense of what the services were costing and whether someone’s pocket was being picked. Not surprisingly, neither party was happy with this pricing structure and it ended up being a source of irritation to both and ultimately of conflict. It is preferable if the services provided by the service provider are individually priced and accurately reflect the parties’ estimates of the costs of providing the services. This means, for example:

• Infrastructure and application services should be disaggregated to identify separately the individual components of the services;
• Transition and transformation services should be separately priced or, if blended into other pricing components, the amount being charged and for how long should be clearly identified;
• There should be a separate charge for the service provider’s account management services, i.e. for the general administration and relationship management services including change management provided by the services provider;
• Termination transition charges should be paid for on a time and materials basis, not blended into and recovered from ongoing services’ costs;
• For each service, there should be base charges that apply to a baseline level of resources with Additional Resource Charges (ARCs) and Reduced Resource Credits (RRCs) for variations from the baseline; and
• Inflation should be specifically dealt with, by geography.

Information

If the price adjustment process is to be successful, the customer and the service provider require information about the service provider’s charges and about market pricing.

Customers frequently refer to their requirement for information about the service provider’s pricing as the need for “transparency”: the service provider should be transparent about what its pricing includes. For example, if the service provider is providing the services using dedicated equipment, how frequently will that equipment be refreshed? If security services are not separately priced but, rather, included in the charges levied for the infrastructure services, what is included within the purview of those services? In the case of services that are charged on a fixed price basis, e.g. application maintenance or support services, what level of contingency has the service provider included to take account of risks including unforeseen circumstances and increased demand?

The need for information goes beyond just having details of the service provider’s current pricing. The customer and the service provider need information about the market pricing of the services that are currently being provided. Here, the customer may be at a significant disadvantage. The service provider should have insight into current market prices from being in the market and competing for new business or from any price adjustments it is forced to make to retain its existing customers. The customer lacks these insights.

For the customer, the best source of information about the market pricing of the services being provided is, of course, for the customer to re-compete the services and find out at exactly what prices competitors are willing to provide the services. But issuing an RFP is a costly exercise and the costs to transition to a new service provider, if that is the result, can be significant and outweigh any cost savings. Still, for the customer to have leverage in any price discussions, the customer needs reliable market information: this usually entails the customer having the ability to use third party benchmarkers such as Everest to obtain data about the market prices of similar services and to indicate how the service provider’s pricing compares to market, e.g. is it in the top decile? The top quartile? About the fiftieth percentile? This does not mean that the customer needs to actually carry out the benchmarking – often the threat will motivate the services provider to “sharpen its pencil” sufficiently and provide significantly reduced pricing that will be acceptable to the customer. However it is important for the customer to have the ability to invoke benchmarking.

There are other sources of information about services pricing that the customer should not ignore, although taking advantage of them will require effort, planning and dedication. The customer may be able to use freedom on information legislation for example to obtain the pricing from government outsourcing contracts. The customer may also be able to compile estimates of market price reductions by using publicly available information such as indices of hardware, software or labour prices.

Process

The customer and service provider should define in the outsourcing contract the price adjustment process that will be followed. This process will need to allow for exploratory discussions, the benchmarking, joint review of the results of the benchmarking and implementation of the results.

The price adjustment provisions in outsourcing contracts are frequently drafted to entitle the customer to invoke the price adjustment process at any time after, say, the second anniversary of the effective date but perhaps not more frequently than once per year. This ignores the reality that many outsourcing relationships take some time to stabilize. Two years may be too early in the relationship and too short a time there to have been significant adjustments in the market price, so that the price adjustment provisions will not be effective. Moreover, after a price adjustment has been implemented, both the customer and the service provider should be entitled to a stabilization period during which prices should not be subject to change and this period should be longer than twelve months. It may be preferable therefore for the customer and the service provider to agree on periodic price adjustments using a cycle that is aligned to the service provider’s likely hardware and software amortization cycles (or designed to take them into account), e.g. every four or five years, perhaps based on anniversaries of the effective date. This will introduce some certainty into the process as well as providing the customer with the benefit that the service provider may seek to pre-empt the price adjustment process by making unsolicited price reduction proposals just in advance of each price adjustment process.

Perhaps the most difficult issue to resolve in connection with the price adjustment process, and the one that cuts to the heart of the customer and service provider concerns, is how to use the results of any benchmarkings that may take place. There are a variety of options including:

• Using the benchmark results as input and information for negotiated price adjustments, without allowing them to be determinative
• Using the benchmark results to support the price negotiations and as the basis for an appeal to expedited arbitration if the negotiations are not successful
• Implementing phased reductions of the service provider’s prices based on the results of the benchmarking
• Implementing immediate reductions of the service provider’s prices to the benchmark standard, possibly with retroactive effect to the commencement of the price adjustment process
• Reducing the service provider’s prices to the benchmark standard, with immediate effect but subject to a maximum reduction in any price of (say) ten percent
• Causing immediate reductions of the service provider’s prices to the benchmark standard, with the service provider having a right to terminate any service towers (often with reduced termination transition fees) in respect of which the service provider is not able to provide the services on a profitable basis.
• Allowing the customer to terminate any service tower for which the service provider does not agree to reduce the price to the benchmark standard.

Which of these options is the right one in the circumstances will depend on more than just the parties’ objectives for the price reduction. It will also depend on the options available to them. For example, if it would require significant time or impose significant costs on the customer to transition services to another service provider, it may put the customer at a disadvantage to allow the service provider to terminate the arrangement if it disputes a reduction in prices based on the results of the benchmarking. In these circumstances, it may be a better option for the customer to specify phased reductions or to limit the magnitude of the price reductions that can be implemented in any one process.

If the customer and the service provider approach the price adjustment provisions having regard to the concerns of each party, it will be possible for them to draft provisions that accommodate the interests of both. In our next posting, we will take a similar look at change management.