Contractual Cost Control in the Time of ‘the Crunch’

June 4, 2008

The impact of the current ‘credit crunch’ is clearly being felt far more widely than in just the financial services sector, as the lack of availability of funds affects the ability of all kinds of organisations to pursue their business strategies. At the same time that budgets are getting squeezed and costs are slashed, outsourcing will clearly grow in importance as a potential strategic option for achieving cost savings. However, it will rarely be possible to get a new outsourcing programme up and running in short order (at least without a very hefty degree of risk); accordingly, if more immediate pay-back is the order of the day, attention will inevitably need to be focused on existing arrangements, rather than solely new ones. What kind of areas in their contracts might customers therefore examine in order to ensure that they are getting maximum value?

The Options

In a well drafted outsourcing agreement, there should be a range of provisions whose operation might have a positive cash flow impact for the customer.


Perhaps the most obvious possibility is the application of a benchmarking clause. Such provisions will generally provide for the service provider’s charges and services to be subject to a review against those provided by comparable suppliers and in relation to similar services and projects, so as to determine whether they continue to represent ‘good value’. For example, if the current economic slow down means that the overall supplier community have fewer client prospects to chase after, it is likely that the increased competition will force them to be correspondingly keener in their pricing. Moreover, the increased profile and service delivery capabilities of offshore service providers (particularly but not exclusively those in India) has also applied a marked downward pressure on pricing for outsourcing projects.
However, before jumping to benchmark the service provider, a customer will need to carefully analyze the scope of the contractual benchmarking provisions. For example:
• Can part only of the charges/services be benchmarked, or must it cover the entirety of the contract?
• Are there any restrictions on who can be used as a ‘comparator’? For example, will the service provider be compared only against ‘tier one’ suppliers, or are offshore suppliers expressly excluded?
• What is the basis for the comparison? Must the service provider show its charges are the ‘best’ of all the comparables or just be in-line with the ‘mean’ result? Is the basis for comparison an average does the provider need to be in the top quartile?
• Who bears the cost of the benchmarking process?
Ultimately, however, the most important consideration is what happens in the event of an adverse result, ie if the benchmarker concludes that the service provider’s charges do not represent ‘good value’ (however that may have been defined). The service provider will invariably argue that this should simply be a trigger for ‘discussions’ as to what should then be done. However, this ignores the likely realities of the situation; benchmarking clauses are rarely exercised, and it is inconceivable that a customer would embark on such a course without having first at least tried to reach agreement with the service provider by way of direct discussions. If the service provider wouldn’t agree to price reductions at that stage, why should it be thought likely to do so after the benchmarking process has been completed? The service provider will no doubt still find causes to disagree with the benchmarker’s findings, or else argue that there are still good reasons as to why its charges should have been found to have been more expensive than those of its competitors.
Some service providers may prove immovable on this point (a common argument being that the original tender/procurement process should be sufficient to convince the customer that it is getting the best ‘deal’ available). If this is the position the customer finds itself in, it should still consider carefully the provisions regarding the cost of the benchmarking exercise; they should ideally provide that the service provider will at least pay the costs of the benchmarker if he/she concludes that the services and charges do not represent ‘good value’, and in such event simply the threat of having to cooperate in the process and ultimately bear the cost of it may be a sufficient incentive for the service provider to offer up at least some cost reductions, in order to avoid such an exercise.

Efficiency or Productivity Savings

Aside from the benchmarking clauses, what else might the customer look for in its outsourcing agreement? In certain contracts, the service provider may have committed to make efficiency or productivity related savings. In many cases this will be a ‘soft’ obligation with nothing in the way of concrete steps to be taken or required cost reductions hard-baked into the pricing regime, but it could still be used to put pressure upon the service provider to demonstrate exactly what it has done in this regard, and/or to offer up cost savings in lieu. Preferably, however, the productivity or efficiency savings will have been incorporated into the contact in the form of more certain and binding commitments, either by way of year-on-year cost reductions or some kind of trackable metric (eg such as a function point analysis for application development services, or test case point analysis for testing services etc). Such a metric should enable the customer to track whether the service provider has in fact delivered the required benefits, and to demand rebates against the charges if it has not.

Re-examining Charging Structures

Another possibility for achieving cost reductions is to look at the charging structure itself. Increasingly, outsourcing deals are set out (whether in whole or in part) on a unitary/transaction based model, such that payment to the service provider either goes up or down in line with demand. Even if the contract in question was not drafted this way at the outset, however, it may well be possible to negotiate with the service provider so as to switch to such a pricing model in the future. With this in place, if the economy’s woes means that the demand for the service provider’s services goes down (eg there are fewer desktops to support, fewer calls for a help desk to service, or fewer transactions to reconcile etc), the customer should see a commensurate reduction in its charges.

Retendering Leverage

Even if none of the above options are available, however, all hope is not lost. There remains for the customer the leverage associated with retendering and contract extensions.
If the relevant contract is reaching its end, both customer and service provider will be turning their minds to the possibility of either extending or retendering the relevant services. The service provider will obviously be loath to lose an existing contract, and will equally want to avoid the costs associated with a competitive re-tender process.  A customer can therefore offer up the possibility of an extension to the existing contract term or possibly even the extension of the current scope of services so as to incorporate additional activities, but only on the basis of a reduction being made to the current level of charges. Accordingly, even if the customer has to accept a longer commitment to the service provider (which should in any event be palatable, if they are continuing to deliver an acceptable service), it may be possible to achieve significant short-term savings. By way of example, a client we have recently advised achieved a 20% reduction in its current costs simply by offering up a chance to negotiate a renewal and extension of the service provider’s current contract on a ‘sole source’ basis.


There seems little doubt that tougher times will continue long into 2008 and potentially into 2009.  Customers would accordingly be well advised to take the time to not only consider new outsourcing initiatives but also examine ways of extracting maximum value and cost reductions from the contracts for the ones they already have in place.

Kit Burden is Head of the Technology, Sourcing & Commercial Group at DLA Piper UK LLP and is an SCL Trustee.