There was a time when the payment mechanism for an average outsourcing transaction would be relatively straightforward. The supplier would simply assess the scope of work involved, the valuation (if any) to be attached to any transferring assets or property and the amounts attributable to any transferring staff and contracts. On the basis of such assessment, it would calculate a fixed price for the services to be provided. However, whilst fixed price arrangements still plainly have their place, today’s outsourcing contracts are characterised by a far greater degree of sophistication in terms of the ways in which the supplier is remunerated. This article evaluates the pros and cons of just a few of the more common options, and offers some practical tips for dealing with some of the issues they present.
Fixed Price
Advantages
The obvious upside of having a fixed price is the budgetary certainty it provides; unless there is an actual change in the scope of what is required, the customer can expect to set its budget for a known quantity and quality of services. This makes it far easier to establish an initial business case for proceeding with the project and thereafter eases the task of benchmarking it against what is available in the market.
Disadvantages
The key problem with a fixed price is that it requires a precise understanding of the nature and scope of the required services, and for them to be precisely encapsulated in the contract. As anyone who has dealt with this process will know, this is far less simple than it sounds! The reality, thereafter, is the likelihood of ongoing tension between customer and supplier as to what is in or out of scope and, in the worst cases, relationships which are excessively dependent upon the day-to-day interpretation of the contract and the application of the change control mechanism.
Moreover, a price which may seem to have been fixed may in practice be anything but, depending upon how the contract chooses to deal with factors such as changes in law or regulation, the impact of force majeure events, and/or failures by the customer to comply with its own contractual obligations (ie if the contract then allows the supplier to vary its prices as a result).
Drafting Tips
From a customer perspective, it needs to be recognised that even the best drafted services description is likely to leave something out or leave some aspects of the services open to interpretation. A useful provision, therefore, is one which provides that the supplier’s obligations (within the scope of the fixed price) are to include those activities which are impliedly, customarily or necessarily included within or as a part of the outsourced activities. Not surprisingly, this can cause some concern to suppliers (particularly if they are not especially familiar with either the customer’s operations or the precise kinds of services in issue), and in this regard a reasonable check/balance may be to place a cap on the amount of “additional” work which the supplier can be required to undertake pursuant to such a provision, before a right to raise additional charges arises.
Time and Materials
Advantages
The upside of a time and materials model is that – in simple terms – you are paying for what you get. If the supplier is able to work effectively and efficiently and/or if the level of demand goes down, the price to the customer should also decrease, so providing an attractive degree of additional flexibility. The degree of dependence upon the accuracy of the original services description is also reduced, as the supplier will be protected from “scope creep” by reason of the knowledge that it will still get paid for all of the services it actually provides.
Disadvantages
Going down this road arguably provides little in the way of an incentive for the supplier to look to provide cost effective or streamlined ways to provide its services, and leaves the customer’s business case in something of a “keep the faith” category. Whatever the expectations at the time of agreeing the contract, what if the supplier cannot in fact undertake the required services any more efficiently than the customer did previously, so that the customer ends up paying more than it did when the service was provided in-house?
Drafting Tips
If the key is to ensure that the supplier is to be incentivised to work efficiently, it may be sensible to agree an overall budget for the services. If the budget is exceeded, the supplier could be asked to share some degree of the risk/pain by way of a reduction in its rates (and – in extreme cases of overrun – perhaps culminating in a right for the customer to terminate the agreement). Conversely, if the supplier works more efficiently than had been anticipated and so proves able to provide the required services to the expected service levels for less than the budget, one might provide for the supplier to share in this “bonus” (eg by allowing the supplier to invoice for a set proportion of the under-run, in addition to the time actually worked).
Unit Based Pricing
Advantages
Unit based pricing (ie reducing the services down to repeated transactions of functions to which individual unit costs can be attached) provides a great deal of flexibility, in that the customer ultimately pays only for the level of demand it has at any one time, and has a significant degree of visibility of the cost of each aspect of the outsourced services. This may be especially attractive to a customer whose business operations are impacted by seasonal variations or other peaks and troughs in demand (as will often be the case with certain BPO deals).
Disadvantages
In order to enable the supplier to set its unit prices, the supplier will need to have a very clear view of what the customer’s existing cost base is, and this will frequently be a major source of debate during the pre-contract negotiations.
The flexibility which is inherent in such a structure also has its own drawbacks. From a customer perspective, there may be concerns as to the supplier’s motives/incentives in relation to reducing the volumes of the relevant transactions or processes to which the prices relate, to the extent that this is within the supplier’s control or influence. Equally, the supplier is likely to have set its prices on the assumption of a particular level of demand/activity (and probably also on the basis of an understanding as to when any particular peaks or troughs in demand are likely to come), and will be likely to look for rights to vary its pricing, gain relief for failures to meet service levels or even to terminate the contract in the event that these assumptions or understandings turn out to be incorrect.
Drafting Tips
One of the key aspects to focus on is how to deal with extreme or unexpected fluctuations in demand, as much for the impact that this will have upon the supplier’s ability to comply with any relevant service levels as for issues associated with costs. The customer may expect unit costs to go down as volumes increase, but the supplier may resist this if it is not able to lay down advance plans for increased demand and thereby achieve reasonable cost savings and efficiencies. The contract should accordingly describe the “thresholds” within which levels of demand may vary, and the pricing (and other contractual) consequences in each case.
Cost Plus/Open Book
Advantages
As this model involves the customer having a full and unobstructed view of the supplier’s cost base in providing the services, it can engender a healthy additional degree of trust between the parties. The customer can take comfort from the fact that it will not be exposed to the risk of the supplier earning “super profits” if in fact it is able to achieve savings or efficiencies greater than those envisaged when any relevant fixed price was set. As the supplier has the reassurance of knowing that its costs will be met in any event, the process of defining the exact scope and nature of the services is also de-sensitized.
Disadvantages
The chief problem with the “cost plus” model is that it removes much of the transfer of risk which is frequently seen as one of the key components of an outsourcing project, and in doing do also removes much of the incentive for the supplier to achieve significant improvements in the services (given the fact that it knows that its potential income will be limited in any event).
Drafting Tips
It is important to be clear on exactly what “open book” is to consist of, as different people can take it to mean different things! At one end of the spectrum, it may be little more than disclosing the time sheets of the individuals who have worked on the project and the receipts regarding any third-party costs incurred, whilst at the other end it will include detailed disclosures of profit margins, contributions to overheads, staff salaries and the like. One must also be clear on what mark up/margin is to be applied, and in particular whether it is to be added to “pass through” costs and expenses.
Summary
In practice, the selection of the pricing model for outsourcing transactions need not be an “either-or” analysis, in that the contract may actually contain different pricing mechanisms for different aspects of the services. The key in this regard is to ensure that all of the different pricing approaches will still work together without undue complexity, and in particular in the event of changes to the contract or the scope of the services at some later date.
Kit Burden is a partner in DLA Piper’s IT&T Group. He can be contacted at DLA Piper Rudnick Gray Cary LLP, 3 Noble Street, London, EC2V 7EE: kit.burden@dlapiper.com.
