Technology Based Outsourcing: The Long and Short of it All

June 30, 2006

The outsourcing industry is abuzz with talk of the need to make outsourcing deals more “flexible”.  All parties seem to agree that flexibility is a desirable thing, with the meaning of the term of course differing depending on what side of the fence one is on.  Of course, there is a variance of opinion amongst customers, suppliers, lawyers and consultants as to where to locate this holy grail of flexibility.  Can flexibility be built into a contract?  How can both parties best ensure that flexibility is a tool available to maintain the relationship over the longer term?  Are smaller deals more efficient in reducing flexibility difficulties than larger deals?  Are there risks in becoming too flexible, from both parties’ perspective?

Challenges relating to flexibility can be broken down into the following:-

·                     How to build it in;

·                     How to keep it, once built in;

·                     How it affects the pursuit of good practice from the supplier’s perspective and good service from the customer’s perspective.

One of the key difficulties with deal flexibility is that it only really becomes apparent whether or not the contract parties succeeded in building it in some way down the road, at which point it is generally difficult to build it in retrospectively without, at least, altering the nature of the deal in some important respects, which is never an easy task.  The problem of lack of flexibility is not necessarily due to a lack of planning or foresight on the part of contract parties but, rather, is inherent in the basic structure of outsourcing. 

Outsourcing – A Paradox

Outsourcing, at its heart, is built on a contradiction.  A general feature of outsourcing deals is the high cost of entering and exiting the relationship.  This tends towards long-term contracts, mainly for cost related reasons. 

It tends to be the case that customers are reluctant to carry one-off entry and exit costs and prefer costs to be amortised over the contract term.  Despite the best efforts of the parties during the negotiation phase, longer term deals are, by their nature, inherently inflexible, given that prices and metrics tend to be projected into the future, based on criteria decided at the outset.  Herein lies the paradox: given that parties cannot predict what the future holds, attempts are made to build in flexibility in order to deal with changes envisaged in the future.  This paradox creates a tension – between framing a secure long-term relationship and flexibility.

Unravelling the Problem

In an outsourcing agreement, the customer essentially gives over the ownership and management of a business process to a chosen supplier.  The larger deals tend to involve significant investment costs, together with switching costs in circumstances of change of supplier.  These factors tend to drive deals towards the longer term.  What the supplier offers the customer is an opportunity to reduce costs and/or improve service, with these factors being of greater or lesser importance depending on the circumstances of the customer and nature of the deal.  The supplier generally amortises its investment involved in the reduction of costs and/or improvement in service delivery over a period of time, generally a fairly long contract term.  Amortisation of these upfront costs, however, is not readily compatible with facilitating changes and improvements during the contract term, namely flexibility.

Another relevant factor is the requirement to build in an element of future proofing. The parties, at contract signature, must at least attempt to establish a baseline for future expectations, costs and services during the contract term.  But any baseline, no matter how well thought out, may not cater for future eventualities.  Baselines are predicated on where the customer believes the business is going, what both parties believe technology will look like in the future and the business plan of the supplier.  In reality, all of these, together with a myriad of other facts which go to constitute contract baselines, will more than likely change over time and the longer the contract relationship, the more likely they are going to change.  Hence, the solution to the problem tends to be the building in of flexibility to deal with future change, essentially the use of flexibility as a form of future proofing.

Restoring Balance

Rather than attempting, at the outset of the contract relationship, to build in flexibility at a global or cross-functional level, a slightly different approach to dealing with the requirement for flexibility is to distinguish between the length of the relationship on a cross-functional basis and the length of the contract.  In other words, while the contract will be medium to long term, the parties relationship in relation to functional areas within the scope of the contract can be broken down into bite-size chunks.

With most outsourcing deals, which encompass different business processes, the different processes may develop and change at different speeds.  For example, in IT outsourcing, the desktop environment changes at a more rapid pace than the mainframe environment.  A customer concluding an IT outsourcing deal has really little or no idea what the desktop environment will be like in five let alone ten years’ time.  By way of example, I am aware of one public sector PPP/PFI deal which related to the development of physical infrastructure with an IT component where at least two potential sub-contract suppliers of desktop environment and ancillary services withdrew from negotiations with the prime contractor (a building company) on the basis that they were not prepared to commit to delivery and support of a desktop environment for a period in excess of seven years.  While the building company thought in the long term, the IT companies could not accept its requirement that the same environment be maintained for a lengthy term.  While this is a rather extreme example, it does illustrate the problem.

In general terms, prices or metrics established at the outset of a contract term can be little more than a figment of the imagination when measured over a lengthy term.  The customer needs to be able to structure the contract so that it is not required to renegotiate the contract due to changes in one aspect of technology or business requirements.  The example is given of the desktop environment, but the principle holds true for the outsourcing of other business processes.  By way of another example, I am aware of a deal which failed to conclude and which related to the outsourcing by the operator of a managed service location of a range of on-site facility management and operations.  The supplier was demanding essentially fixed pricing over the lengthy contract term.  It took some time for the penny to drop, but eventually the operator worked out that fixed supplier pricing would eventually render their service offering uncompetitive in the market place, given that co-location and managed service prices were more and more viewed as a commodity, with price pressure downwards.  Negotiations ceased thereafter.

It is important that both parties understand what is being bought; in the second example above, the customer was naive.  While it may make sense from a structural perspective for a customer to buy all components of the services from the same supplier, thereby assisting the supplier in achieving synergies and economies of scale, it may be the case that technology and business change will drive the service components in different directions.  It is this problem which the contract must do its utmost to deal with.

A Proposal

In structuring the contract for flexibility, one approach to consider is to utilise a master procurement vehicle, essentially a master service level agreement (SLA), which will encapsulate high level issues associated with how the customer and supplier will interface.  Beneath this might be put in place a series of SLAs relating to differing aspects of the service, to which potentially different terms may apply.

While this is, admittedly, on the face of it, a complex requirement, it should not provide the supplier with too many difficulties, given their fluency in the language of service level requirements.  It may, however, take the customer some time to come to grips with the need to manage different areas of service delivery in slightly different manners, whilst retaining an overview of the services.  Undoubtedly, it makes the management of the key performance indicators, or service level regime, slightly more complex than would be the case if all services were managed as an integrated whole.

The customer needs to keep one eye on the issue of incentives for the supplier.  If a structure is put in place utilising a master SLA, together with per function sub-SLAs, then it is necessary to keep the supplier interested and motivated as the customer requirements change over time and the SLA regime changes over time.

In relation to individual areas of technology, it is not in the customer’s best interest to sign contractual commitments which go beyond the natural life cycle of technology or, indeed, of its business.  Large-scale IT outsourcing has been traditionally marked by longer terms, with periods of ten years not being unusual.  There is a point at which the supplier is in a position to amortise its costs, without resulting in unpalatably high service charges.  If this line in the sand can be found, this may be the preferred contract term.  Of course, the customer should have the ability to extend the contract term, but the initial award and the basis upon which pricing is calculated may well be for a period less than a longer term of, say, ten years.

There is a noticeable tendency for customers to start to grumble to their outsourcing suppliers within approximately 6 to 12 months of contract signing, when steady-state services have generally commenced.  It is not unusual for both parties to accept at that stage that they did not quite get it right during the negotiation phase in terms of service scoping and service levels and for a certain amount of contract renegotiation to take place.  Of course, unless the initial contract structure was flexible, it is difficult for the customer to force through an adjustment process, which can itself take a number of months to put in place.  If the customer did not get it quite right initially and the supplier is sitting on a lengthy contract term, then the customer has little leverage over the supplier and is probably not in a position to threaten to go back to the market.  The implied threat of going to the market does put the customer in a strong position in circumstances of contract “realignment”.  The essential point is that shorter contract periods do tend to shift the balance of power slightly in the direction of the customer in terms of managing the requirement for flexibility in relation to the service detail.  It may be a subtle distinction, but the supplier knows it has a lesser rather than greater period left in the contract term, which is an incentive for more reasonable discussions with the customer.


In terms of achieving the Holy Grail of flexibility, one option which might be considered by customers is to put in place an outsourcing contract for a suitable contract term and beneath this to put in place one or more SLAs in relation to functional categories which are for a similar or lesser period, depending on the nature of the technology.  These could be supplemented by automatic renewal provisions in these shorter agreements.  This essentially turns the outsourcing contract into a form of master contract, beneath which sit a number of individual SLAs.  There is a distinction here between contract term and duration of functional relationship.  There is a balancing act to achieve in this arrangement, between a suitable contract term, which allows for amortisation of costs, acceptable service charges and suitable service delivery terms, together with duration in relation to functional areas.  Use of this structure, together with a robust contract management and review procedure, does tend towards building in a degree of flexibility.  Flexibility is certainly in the interests of the customer, given its changing business and technology requirements, and, ultimately, it is in the best interests of the supplier, given that a satisfied customer is a loyal customer.

Of course there is no magic formula to keep both parties happy in this most complex of contractual arrangements.  However, the building in of flexibility at least provides a working methodology to allow both parties attempt to balance their requirements over the contract term. 


Pearse Ryan is a Partner in the Technology Group at Arthur Cox.