December 15, 1995
A contract is an agreement between two or more parities. To expand on this definition, an outsourcing contract is usually between two parties where an exchange of human and/or technical resources takes place. This can be a relationship for one particular job or task, for example converting files from Mac to DOS format, or for a long period of time such as providing help desk services. "The contract is a vehicle for articulating and reviewing what each party expects from the other." (Judenberg, 1994, p.38)
The following will explain what to look for in a properly written IT outsourcing contract in the past and present. There are also examples of what can happen if proper care and diligence is not followed.
The number one strategy in the past was to discard the vendor's standard contact. (Lacity, 1995) (Minoli, 1995) All vendors contracts were assumed to be one-sided and favor the supplier. Hidden costs were thought to be the biggest outsourcing problem and in almost every supplier written contract there assumed to have hidden costs, adding up to hundreds of thousands of dollars. As noted by a metal company: "The outsourcing vendor wanted it day one net fifteen. We got it to in arrears net forty-five. There was a difference in a ten-year contract of $8 million." (Lacity, 1993, p.81) The other major problem with supplier written contracts were when hidden clauses limit company's operations. One U.S. chemical company in contract negotiations inserted a provision to allow it to solicit bids from third party software firms when it wanted to develop new software. But the chemical company did not realize there was a buried clause that would award the support contact automatically to the IT operations supplier. (Lacity, 1995)
As both parties want to have the contract negotiations finished there was a temptation to try to bring it to a fast closure. The outsourcing vendor was thought to try to get the contract signed before all items are clearly identified. The customer might be assured with "We'll take care of the details later." (Lacity, 1993) Once the contract was signed the vendor does not have the change anything; therefore, do not sign incomplete contracts.
When hiring outsourcing experts it was recommended to hire a technical and a legal expert. These experts were to counterbalance the advantage vendors have in contract negotiations. Studies have show that "experts are a critical success factor in negotiating an equitable contract." (Lacity, 1993) The technical experts have two functions: 1) to measure the baseline services and 2) to convert the customer's terminology to the vendor's environment. The legal experts work with the clients own legal department to make sure the contract document is accurate.
The second most important strategy was to measure everything during the baseline period. Whatever was measured during the base period became the yardstick of services to be provided. This was to be the base bundle of services and anything over this base would have extra charges. The data processing and telecommunications services have very easily monitored levels of service (i.e. how jobs submitted, tape mounts, data storage, system availability). The only real problem is that the customers "systems may perform differently on the vendors machines" (Lacity, 1993) and the vendors test environment may vary significantly from the operating environment.
Develop service level measures and reports to express the level of required service. The same service levels can be interpreted in many ways. In the case of Energen petroleum, they had "assumed that the 99% availability requirement meant that all nodes on the network had to be up and running 99% of the time. The supplier, however, interpreted it to mean that the host node had to function 99% of the time." (Lacity, 1995, p.88) Also, in many cases if the proper service level reports are not requested in the original contract the supplier has an obligation to create them without a fee.
A specific cost escalation procedures should be clarified. The usual process was to find which party was at fault of a particular drop in the service levels. The vendor should not be punished for errors made by the customer. To decide who was at fault when service level fall below targets was not a trivial task. There had to be a specific escalation procedures for non-performance. All items of non-performance should be divided into critical or non-critical items to prevent micromanagement. The critical items should be looked at right away and those remaining can be dealt when time permits.
It was important to have cash penalties for non-performance to compensated the customer for service degradation. These monies can be escalating with frequency of problems with service. For example, the first nonperformance will cost $25,000 and the second time cost will rise to $50,000. (Lacity, 1993) It has also been "noted that penalty clauses do not fully compensate the customer. Rather, the purpose of penalty clauses is to ensure that the vendor's senior management will attend to service level problems." (Lacity, 1993, p.84)
In most outsourcing contracts a certain amount of increase in usage is free. This is to allow the customer to share in the performance improvements made by the supplier. The growth rates are very difficult to estimate and can be quite costly if incorrectly calculated. If a 6 percent growth is negotiated and a 10 percent growth is actually obtained the customer will have to pay extra or try to reduce growth.
A clause for volume fluctuations caused by acquisitions, mergers, or sales of business units should be included. This adjustment of charges to changes clause will allow the customer to operate its business without having to pay for services which it might not needed anymore. Also, to include is the ability to promptly add more services with merger and acquisitions.
To include a termination clause is to protect both parties. One common reason to terminate a contract is the failure to receive proper service. (Judenberg, 1994) An extraordinary event clause can be negotiated which will only take effect if there is a significant change in the company's location, product line, or financial status. (Minoli, 1995) If proper notification, of a specific time period before termination, is not given then a severe penalty may be charged.
The "change-of-character" clauses "states that the customer will be charged for any change in functionality." (Lacity, 1993) For example, a contract has been written to have all personal computers (PC) services by a vendor. With the current technology of local area networks (LANs) most of the computers are now networked. The vendor may claim that this has changed the character and the customer may claim it is just different technology.
In the present day outsourcing contract negotiations all of the above point have to be kept in mind but is has to be realized that there has to be trust between the parties. Also, the outside contractors should be considered as part of the group that hired them. (Meyer, 1994)
"No matter how much detail and thought goes into drafting the contract, the resulting causes will provide imperfect protection if things go wrong. Indeed, the process of contract drafting is likely to be more important than the contact." (McFarlan, 1995, p.17)
"During negotiations, it is important that both sides be open in declaring what their future plans and strategies are, so that the outsourcer can accurately assess the service to be offered as part of the deal, and the organization can form realistic expectations of what can be achieved in terms of costs and service metrics." (McFarlan, 1995, p.20)
When an outsourcing contract is created it has to be written with the idea of a partnership agreement. The idea is not who can get a better deal over the other party but how well both stake-holders will do in the relationship. It is not beneficial for the client to win at the expense of the service provider because this might force the service provider into financial difficulties and is it this case both firms will lose. (Dixon, 1995)
When Vaughn Hovey (director of information processing services at Eastman Kodak) was asked about his experience with outsourcing, he stated: "Outsourcing is a collaborative relationship that has to be worked on. The lawyers are very helpful in structuring a contract. Our job is to make sure we don't need them throughout the year. ... Clear expectations are important, but flexibility and personal communications are vital." (McFarlan, 1995, p.18)
Before signing any outsourcing contract it must be realized that the IS industry is changing at an exponential rate and that there is no way to predict with any accuracy 5 or 10 years into the future. With all this uncertainty, the only way to successfully outsource is to setup a partnership agreement with a supplier. It is important to specify the contract as much as possible but not to write down every possible contingency and definitely not to have the contract "written in stone." If conditions change the contract should be flexible enough to beneficial both parties to keep a win-win condition.
The issue of setting up a proper contract comes down to a simple concept of trust, if there is confidence that when conditions change that both parties will re-negotiate the contract in good faith then partnership will last.
Dixon, T.O. (1995, October 25). Address. Speech presented to Management Science 604 -Principles of Information Systems Class, University of Waterloo.
Judenberg, J., "Applications Maintenance Outsourcing an Alternative to Total Outsourcing", Information Systems Management, Vol 11, Fall 1994, pp. 34-38.
Lacity, M. C., Hirschheim, Rudy, "The Information Systems Outsourcing Bandwagon", Sloan Management Review, Vol 35, Fall 1993, pp. 73-86.
Lacity, M. C., Willcocks, L. P., Fenny, D.F., "It Outsourcing: Maximize Flexibility and Control", Harvard Business Review, May-June 1995, pp. 84-93.
McFarlan, F. Warren, Nolan, Richard L., "How to Manage an IT Outsourcing Alliance", Sloan Management Review, Vol 36, Winter 1995, pp. 9-23.
Meyer, N. Dean, "A Sensible Approach to Outsourcing - The Economic Fundamentals", Information Systems Management, Vol 11, Fall 1994, pp. 23-27.
Minoli, D., "Analyzing Outsourcing - Reenginerring Information and Communications Systems", 1995.