Long Term Outsourcing Relationships – Customer and Service Provider Concerns

The Clock for the Long Now, a project of the Long Now Foundation, is intended to keep time accurately for 10,000 years. It was conceived by Danny Hillis in 1986 as a way of connecting us with future generations. Unable to predict what the world would look like in 10,000 years, but faced with the challenge of developing an object that would last that long, keep time accurately over the duration and be useful, the designers were forced to abandon short term thinking in favour of the long term. They had to deal with the most fundamental issues such as the problem that no one has any idea what measure of time the human race will use in the year 12000. They began, not by trying to make existing time pieces last for longer and longer periods of time, but, rather, by identifying the basic design principles that such a clock would need to satisfy; things like longevity, maintainability, transparency and scalability. (For more information on the 10,000 year clock, see http://electronics.howstuffworks.com/gadgets/clocks-watches/10000-year-clock.htm or http://en.wikipedia.org/wiki/Clock_of_the_Long_Now.)

There is a connection between the Long Now Foundation and the outsourcing industry. And no, notwithstanding the secret wishes of service providers, the lesson is not that now is the time to start thinking about 10,000 year contracts. Instead, it is their approach to developing an object that would last, continue to function, and be useful for 10,000 years can act as a guide to the outsourcing industry as it grapples with how to design and implement long term outsourcing relationships. As the Long Now Foundation began by identifying the basic design principles of the 10,000 year clock, the right way to tackle the problem of long term outsourcing is to first identify the “design principles” that long term outsourcing relationships need to address, i.e. what are the concerns of the customer and the service provider with long term arrangements? Once the concerns have been identified, it will be possible to talk about the provisions that should be included in the outsourcing contract to deal with them.

This week’s posting and the one to follow will look at long term outsourcing relationships and will follow the approach suggested above. We will begin by identifying, in this week’s posting, some of the different customer and service provider concerns that arise from the long term nature of the relationship. The next posting will examine how to address these concerns in structuring the outsourcing relationship and in drafting the contract terms. 

One preliminary point is in order. For the purposes of this posting, a long term outsourcing relationship will be considered as anything with a term of six years or longer. Although the six year term is not critical for what follows, it does separate these contracts from those that typify the current trend to shorter term transactions. The webinar, The Canadian Outsourcing Market: At A Crossroads, presented by the Centre for Outsourcing Research and Education (CORE) on June 23, 2011, noted that the term of outsourcing agreements has gone from an average of 7 years in 2002 to 4.58 years in 2010. CORE did recognize however that some customers are resisting the trend to short term transactions by consolidating service providers and moving to longer term relationships.

The concerns that long term outsourcing agreements need to deal with include the following:

Pricing: This is one of the biggest issues, for both the customer and the service provider. Customers are concerned that, regardless of how competitive the pricing may have been initially, by the time six or more years have elapsed, they will be paying far too much. And the available price adjustment mechanisms do not appear to be particularly effective at responding to these concerns. Most favoured nation clauses are difficult to negotiate, hard to enforce and of limited value in keeping the service provider’s prices at market levels. Benchmarking provisions may be easier to negotiate into the outsourcing contract, but they are time-consuming and costly to exercise and implementation of the results can be contentious. Even where the customer anticipates that it will be able to use other mechanisms to encourage or compel the service provider to have discussions about pricing, e.g. the threat of re-sourcing, in-sourcing or terminating services, the customer will frequently be hamstrung in any resulting negotiations by the lack of meaningful information about the components of the service provider’s pricing. Often, for customers, the best guarantee of obtaining market competitive pricing appears to be a re-compete.

The service provider’s pricing issues are at the other end of the teeter-totter. In multi-tower transactions, the service provider may be concerned that when any price adjustment mechanisms in the outsourcing agreement are invoked, they will allow the customer to reduce the prices of the profitable services, without taking account of the fact that that pricing is cross-subsidizing the lower margin, less profitable services or that part of the reason for the higher price of these services is amortization of the costs of the account infrastructure that are not separately charged for. In back-end loaded deals where, frequently, the higher profit in the out years compensates for lower margins during the early, more costly years of the transaction, the service provider worries that the customer will quickly forget these trade-offs once the customer has reaped their benefit: the customer will push for market pricing in the later years of the outsourcing arrangement that never allows the service provider to recoup postponed profits from the early years.

Coping with Change: For both customers and services providers, the ability of long term outsourcing relationships to deal adequately with change is a serious concern. The change order processes that are customary in outsourcing contracts usually categorize the changes that are likely to occur, e.g. material changes, contract changes, operational changes and emergency changes, and define specific procedures to deal with each type of change. The change order processes can be well suited to dealing with these sorts of discrete changes and can do it very well over the entire term of the outsourcing agreement. What they are not as well suited to dealing with is the external events that, while they may affect the customer or the service provider, do not impact the services directly. Nor are the change order processes appropriate for dealing with the changes that occur gradually over the term of the contract but where the cumulative effect can be great.

The issues that these types of changes can create, and that need to be confronted in contracting for a long term relationship, touch all aspects of the outsourcing. They raise business, financial and technology concerns:

    (i) Business Issues: The potential business changes that the customer should be considering are those relating to its business, the business of the service provider and the market place in general. On the one hand, the customer needs to recognize that its business will evolve over the term of the outsourcing relationship, whether as a result of Mergers and Acquisitions or changes in its production processes, locations, clientele, products or services: the customer should ensure that the outsourcing relationship is sufficiently flexible to accommodate these changes. But the customer also needs to worry about whether the service provider’s business will evolve to keep up with the market, changes in the financial condition of the service provider and even the possibility that the service provider ceases to do business. And, at a “macro” level, the customer should be anticipating changes in the vendor market place such as the disappearance of existing service providers and the emergence of new competitors, product offerings and solutions.

    For each of the potential business changes that the customer should be anticipating, there are reciprocal service provider issues. The service provider needs to consider how its business will evolve – what happens if the market evolves away the specific services being purchased by the customer but the customer refuses to move with the market and insists on staying with the same services? The ability to leverage costs across multiple customers that enable the service provider to provide cost effective services may evaporate in the future, leaving the service provider supporting a costly, dead-end service. Or changes in the customer’s business may undermine the outsourcing by removing, from the scope of the outsourcing, services that were fundamental to the service provider’s solution. And, again at the macro level, changes across an entire industry segment can fundamentally alter the nature of the outsourcing transaction and create challenges for the service provider such as occurred in the financial and automobile manufacturing sectors following the recent recession. 

    (ii) Financial Concerns: We touched on some of the financial issues in the discussion on pricing above. One specific aspect of the customer concerns that, over the term of the outsourcing relationship, its pricing will become uncompetitive, is the cumulative impact of gradual year-over-year declines in market price: although initially the customer’s pricing may have been ahead of the market, after six or more years of small declines in the market price, the customer’s pricing may be significantly above market. Correspondingly, the service provider may be worried that, in the absence of appropriate Cost of Living Adjustment (COLA) provisions in the outsourcing agreement, increases in its costs of providing the services will not be properly accounted for and its profit margins will gradually be eroded over the term.

    (iii) Technology Change: The technology changes that the customer needs to anticipate relate to the specific services that are being provided to the customer as well more general technology change. The customer will want to ensure that the hardware and software being used to provide the services are refreshed every three to five years and that the service provider does not continue to operate using outdated or end-of-life systems that barely scrape by. How to build these technology refreshes into an outsourcing agreement and to properly account for the costs in a market where equipment costs are declining and labour costs are stable or increasing is a challenge. But the technology issue encompasses more than just contracting for periodic technology refreshes. The customer will also want to know that the service provider has kept up with changes in technology, both gradual evolutionary change and “the next big thing”, and that the functionality of the solution the service provider is offering is at market. The customer does not want to find itself locked into a technology solution under a long term outsourcing that it would not accept if the services were being re-competed.

    Equally, however, the service provider has to deal with customers who are, for whatever reason, reluctant to embrace new technologies. For the service provider, it will be important that any technology currency obligation that, say, requires the service provider to remain at “n-1”, apply equally to the customer and that the customer be responsible for the costs the customer incurs in so doing. If the customer does not remain current, in a long term outsourcing relationship, the service provider may well find itself forced to provide costly support on a dedicated basis (because no other customer is using the technology) for outdated technology.

Qualified Personnel: In contemplating a long term relationship, the customer may be concerned because, over the term of the relationship, the representatives of both the customer and the service provider who were involved in the initial negotiations will move on to other activities, taking with them both their understanding of contract terms and their appreciation of the trade-offs that were involved in negotiating the contract. Their replacements may not have the history of the transaction or a good understanding of the contract terms. The customer needs to anticipate how it will maintain the perspective and knowledge of the transaction that it requires to manage the outsourcing transaction in future in the face of these challenges.

Lack of Attention: As the customer considers entering into a long term outsourcing relationship, the customer will be concerned that it not be taken for granted over the term of the relationship. Early on in the term, the service provider will willingly dedicate its “A team” to addressing customer requirements, will provide new technology and will propose innovative ideas. But outsourcing relationships frequently coast into middle age where the services and the technology become stale and outdated and whatever proposals the service provider delivers no longer address customer concerns or delight the customer. The challenge for the customer, at the time it enters into the outsourcing agreement, is how to maintain the initial, high level of intensity throughout the term.

Conclusion: This list of concerns set out above is not intended to be comprehensive. However it is intended to identify some of the issues that the customer and service provider will need to consider if they are to structure long term outsourcing agreements for success. In the next posting, we will look at some sample contract provisions that respond to these concerns.

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