Service Level Earn Backs in Outsourcing: Thinking About the Issues

As service levels and service level credits have become a standard component of outsourcing agreements, service providers have responded with requests for earn backs: the right, if a specified level of performance is achieved, to earn back, or not have to pay, the service level credit. However, if earn backs are to be included in an outsourcing agreement as part of a service level regime, they need to be defined carefully at the beginning and integrated into the service level methodology: when they are included late in the game, as a concession granted by the customer in response to a service provider’s request to mitigate the impact of service level credits, they run the risk of undermining the service level regime. In this note, we describe two alternative approaches to earn backs and analyze some of the issues the customer and the service provider need to address in implementing an earn back regime in an outsourcing agreement. The focus of the discussion is on earn backs. This is not a general discussion of service level regimes and we will not go into any detailed discussion of different service level methodologies.

I. EXAMPLES

There are at least as many different ways of implementing earn backs in an outsourcing agreement as there are ways of defining service levels. Two examples are set out below. Each example assumes that for each service level, there are two service level metrics: there is a base or expected service level metric, establishing the minimum level of performance to be provided by the service provider, and there is a target service level metric that specifies a higher level of performance. The target service level metric may be used in the outsourcing agreement to reset the expected service level metrics, it may be connected to the service provider’s right to receive additional work or, as in the examples below, it may be integrated into the earn back regime.

In both cases, the earn back must be applied against the service level in respect of which it was earned. An earn back received for achieving the target service level metric for, say, server uptime, cannot be applied against a service level credit that arises from the failure to meet the service level metric for a different service level such as for incident management.

Example One: After the Fact Earn Backs 

Under this approach, earn backs are earned after the service level failure has occurred.

If, after a service level failure that entitles the customer to a service level credit occurs, the service provider achieves the target service level metric for the service level for two months in succession, the service provider will not be required to provide the customer with the service level credit. If there are less than two months remaining in the term of the outsourcing agreement, no earn back will be available.

Example Two: Advance Earn Backs 

Under this approach, earn backs are earned in advance and applied against subsequent service level failures.

For every two consecutive months in which the service provider achieves the target service level metric in respect of a service level, the service provider receives an earn back. The earn back is equal to fifty percent of the service level credit that would be payable for a service level failure in respect of the same service level that occurs within twelve months of the time the earn back is received. The service provider cannot earn more than two earn backs, i.e. more than one hundred percent of the service level credit that is payable for a service level failure, in any twelve month period. An earn back expires after twelve months or on the earlier expiration or termination of the outsourcing agreement. The earn back cannot be monetized.

If, in the twelve month period after the earn back is earned, the customer adjusts the weighting or penalty attached to a service level metric to reduce it to zero, the running of the earn back’s twelve month survival period is suspended until a non-zero weighting or penalty is once again attached to the service level.

II. ISSUES

Earn backs may come into an outsourcing agreement in various ways. They can be designed into a service level regime by the customer at the very beginning. They can be proposed by the service provider in its RFP response. Earn backs may also be introduced during the negotiating process as a way of mitigating the impact of service level credits. Regardless of how and when earn backs are introduced into the outsourcing agreement discussions, certain questions need to be answered in integrating the earn backs into the service level regime, including the ones set out below.

1. Level of performance

What level of performance does the service provider need to achieve and over what period of time to be entitled to an earn back?

In both the examples set out above, the service provider became entitled to the earn back for achieving the target service level metric, i.e. a level of performance above the base or expected level that the service provider was responsible for achieving. And in the second example (although this could equally well have been built into the first), the earn back was earned in fifty percent increments.

The point is that, in these examples, the earn back was received for achieving a higher level of performance on a consistent basis than the expected, contracted for level of performance. This reflects an approach that views the purpose of earn backs as being to provide an incentive to the service provider to perform at a higher level. If service levels define the basic level of service to be provided for the fees paid by the customer, and the service level credit reflects a penalty to be paid by the service provide for failing to achieve this level of performance, then it would be incongruous to award an earn back for merely achieving the agreed expected level of service. The service provider needs to perform at a higher level to be entitled to relief from the consequences of a service level failure.

There is another perspective on earn backs that views them as a counterbalance to the service level credits. If the service provider is exposed to the risk of having to provide service level credits for failing to meet the service level metrics, so too the service provider should be rewarded and receive an earn back if it meets the expected service level metric. This is seen most frequently with after the fact earn backs (Example One above) where the service level failure is forgiven if the service provider meets the service level metric for the two or three months following the failure.

2. Scope of the Earn Back

What aspects of the service level failure are mitigated by the earn back?

In the examples described above, the earn back only releases the service provider from the obligation to provide service level credits. However, the implications of a specific service level failure may extend beyond the obligation to provide service level credits. In defining the scope of the earn back, the customer and the service provider need to consider whether the earn back will also extend to other consequences of a service level failure including:

1. Is the service provider entitled to apply an earn back against a service level failure even if the service provider materially misses the expected service level metric or are there some service level failures, e.g. achieving only fifty percent of the expected service level metric, that are so egregious an earn back is not available to the service provider?
2. Will the earn back mitigate other aspects of the service level regime or only the individual service level credit? For example, some service level regimes include escalation factors that increase the size of the service level credit when there are successive service level failures. This is the case where the first service level failure gives rise to a service level credit of $X, the second consecutive service level failure gives rise to a service level credit of 150 percent of $X and the third consecutive service level failure gives rise to a service level credit of 200 percent of $X. In such a case, will the escalation factors still apply to the second consecutive service level failure if the first failure is mitigated because of an earn back available to the service provider?
3. Is the earn back also deemed to mitigate any damages that may have been suffered by the customer as a result of the service provider’s non-performance? Is the customer still entitled to make a claim for any damages it may have suffered because the service provider did not meet the service level metric?
4. Does the earn back prevent a service level failure from counting toward any termination rights the customer may have based on service provider’s failure to meet service level metrics? For example, if the customer is entitled to terminate the outsourcing agreement if the service provider fails a service level three months in succession or four months in a rolling twelve month period, will an earn back that is available in respect of a service level prevent the service level failure from being included in determining the customer’s termination rights?

3. Timing

When does the earn back methodology come into effect?

The examples above assumed that the service level metrics had stabilized and that the services were in a steady state. During the outsourcing transition and stabilization period, the customer and the service provider are focussed on issues such as whether: (i) the right aspects of the services are being measured; (ii) the service level metrics have been set at the proper level; (iii) the service provider has had sufficient time to implement the infrastructure necessary to deliver the services; and (iv) the tools and processes are in place to track performance. It is difficult to implement an earn back regime during such an unsettled period and there may not be any meaningful service level credits arising at this time. The earn backs regime should only be implemented once the service levels have stabilized.

4. Earn Back Period

During what period of time can the earn backs be earned?

A version of this question needs to be answered both for earn backs that are received after a service level failure occurs (Example One) and for those that are earned in advance (Example Two). The period of time should be sufficiently long to provide the service provider with a realistic chance of receiving the earn back as a result of diligent and focussed efforts, but not so long that it is almost a certainty that the service provider will achieve the earn back or, in the case of advance earn backs, have one or two available whenever a service level failure occurs.

5. Administration

Are the metrics defined and is the functionality in place to allow the earn backs to be calculated, tracked and applied?

Earn backs may be easy to define in principle or at a conceptual level. However, if the earn backs are to be implemented in an effective manner as part of the service level regime, the service level metrics need to be defined, levels of performance must be measured and earn backs calculated and the expiration or application of the earn backs should be tracked.

This may be easier said than done. The parties may not have defined the target metrics for each service level, so that they are forced to choose between basing the earn back on expected service level metrics or establishing target service level metrics in an ad hoc manner. It may also be the case that the standard service level reporting provided by the service provider does not include the functionality to handle earn backs, to link them to the service provider’s invoicing procedures or to be auditable. Implementing the earn back functionality will then come with additional costs which the service provider will be forced to absorb or the customer will have to pay.

The customer and service provider also need to determine how after the fact earn backs (Example One above) will impact the customer’s payment obligations. The customer may prefer, from a cash flow perspective, that a service level credit not be applied against the service provider’s invoice until it is clear that no earn back is available rather than having to reverse a service level credit in future when the earn back becomes available.

Earn backs can supplement a service level methodology and provide additional incentives to the service provider to meet or exceed its obligations. However the implementation needs to be done carefully and after a full consideration of the issues.