IT service suppliers want to have a pricing structure in their contracts that is workable in practice and enables them to make a fair return over the term of the contract. However, both private and public sector IT service contracts contain increasingly complex pricing structures, often due to the demands of the customer and the nature of the projects. In the light of this, it is important for both customers and suppliers to have an understanding of the key issues relating to the charging mechanisms being adopted.
Service Charge: A Key Part of the Contract
After the description of the services to be provided, the service charge is generally the most fundamental and key part of a contract for IT services. The services may relate to running a customer’s IT infrastructure or may be for the outsourcing of their entire IT function. The contract represents an opportunity for the customer both to save costs and improve its IT service by benefiting from the expertise of an external supplier. Obviously, this is dependent on the customer negotiating a price which allows it to achieve this saving but, at the same time, provides the supplier with a financial return that will incentivise it to improve existing service levels. IT service suppliers, as opposed to hardware vendors or software licensors, need to be sure that they will obtain sufficient return on their investment to make the project worthwhile.
That investment will not only relate to the people involved in providing an ongoing IT service, but could involve development costs up front for new and improved services to be provided to the customer. A typical example, which often forms a part of a larger IT contract, is a helpdesk service included as a part of the outsourcing of the customer’s IT operations. Any respectable IT company will expect to take over an in-house helpdesk and improve the service as well as being able to demonstrate a quick response time to requests for help. This will involve some up-front development plus retraining and, possibly, recruitment of additional staff. It may well involve relocating the helpdesk from the customer’s premises to the IT company’s. The costs of this need to be factored into an appropriate service charge.
Basic Types of Service Charge
In a long-term service contract the service charge needs to be set out in detail with sufficient certainty to withstand the passage of time. It should also be fixed for the benefit of both parties. It is hard for a customer to accept the service provider charging on a time and materials basis for its costs plus an element of profit. Even if the service charge arrangements are on an open-book principle (see below), the customer will worry it is being overcharged. On the other hand, a supplier is generally prepared to accept a fixed price (at the right level) but in doing so will want to see flexibility and a sound change control process (see below) to protect it against unexpected developments. In a development contract over say a year or two an alternative is a contract based on a time and materials charge each month, but subject to a budgetary band within which it must fall or the contract price will need to be renegotiated. The work to be carried out during that month can be expressed in terms of man-days of effort that the supplier must provide for the price.
Negotiating the Service Charge
Often the negotiations over the service charge rumble on in the background while the rest of the contract is being negotiated. To a degree this is reasonable because the process of negotiation tends to mean that the service description evolves as a deeper understanding of the customer’s requirements and the supplier’s solution evolves. It is important that the service charge negotiations are not finalised too early to reflect this evolution. Nevertheless, the service charge does need to be tied down and expressed in the contract prior to the end of the contract negotiation process – and it is suggested not in a late-night negotiation right at the end. The service charge schedule is often quite complex and will need to cover different elements of the service charge. Too much reliance on last-minute negotiations, which are sometimes inevitable, tends to give one side or the other the whip hand, depending on who is under more pressure to sign the contract. It rarely allows a proper capturing and documentation of the service charge in the contract.
Team Approach
It is important that the lawyers and project directors, in addition to the finance advisers, understand and agree the service charge arrangements. This will then facilitate the proper and clear documentation of the price for the contract service. Uncertainty about the service charge can lead to deterioration in the relationship between the parties and, at worst, can degenerate into a serious dispute. The very process of properly negotiating and reflecting the service charge arrangements in the contract will help to further the parties’ understanding of the commercial bargain which they have struck – which should facilitate the performance of the contract.
The Service Charge Schedule
Typical IT service contracts will have a general commitment to pay the service charge in the terms and conditions with a detailed schedule setting out all the specific elements of the service charge. This will identify not only what has to be paid, but the payment terms usually based on monthly or sometimes quarterly billing arrangements. It is important that the details of the service charge are understood by both sides and not only by their respective financial advisers. Sometimes the detail of a service charge regime is contained in a financial model which is used for the bid process to demonstrate the pricing offered by the supplier and then forms a part of the contract. Financial models are typically complex and contained in voluminous spreadsheets which do not necessarily lend themselves either to understanding or to the legal and commercial certainty required for a service contract. One way round this is to be sure that the principles are reflected in the text of the schedule (which takes priority), with the details contained in an attached financial model.
Service Credits and Service Levels
The service charge will be closely linked to service levels and typically to a service credit regime whereby, at the end of each payment period, a service credit will be deducted from the service charge to the extent that agreed service levels have not been met. There are also contracts with a service charge uplift which can act as an incentive to a supplier if the service levels are exceeded.
Clarity and continuity is critical in relation to the service credit regime. Both parties can become intimidated by service credit provisions (which can be very complex), so there is a need to encourage a regime which is both transparent and practical to monitor and administer. Inevitably informed suppliers will have to increase their initial bid prices on the basis of the likely level of service credits they will incur, although the customer may become aware of this if open-book accounting is adopted (see below).
Some suppliers (and customers) prefer not to use service credits at all. They can distract from service quality by focusing on narrow measurements rather than required business outputs. In some service credit models, it can also take a long time to calculate what service credits the customer is entitled to and the amount may turn out to be insignificant compared to the problems caused by poor service. On the other hand, it is conceivable that if a customer can claim service credits which far outweigh the loss the customer might have suffered, then payment of service credits could constitute a penalty clause, which will be unenforceable as a point of law. An alternative is to require the supplier to provide additional resources when service quality slips, for example, to put support technicians on site where the customer had not previously had any.
Good drafting is particularly important for service level agreements (SLAs). The supplier may be tempted to agree high standards, knowing that they will sometimes fail to meet service levels but that their pricing accommodates a level of service credit payments. This protects the supplier as long as the ‘failure’ does not also trigger termination provisions even though the customer may consider the upper end of service levels to be the quality it requires and any payment of service credits to indicate poor service.
In efficiency terms, it is best for the customer not to require the supplier to exceed realistic service level expectations as that often entails price consequences. For example, if the customer only needs 50% of issues resolved on the first call, requiring 90% resolution would imply paying for a higher service level.
Both parties should give serious thought to defining service levels carefully in the contract. It can often be difficult to clearly specify or even understand the customer’s present internal service levels, as the customer may have no definition of the existing service level. SLAs also need to recognise that there will be occasions when the supplier will be unable to meet service levels, even in a well-managed contract where the
Changes
The service charge may be subject to agreed increases every year with reference to the Retail Price Index or other indices. The choice of indices is quite important since, for example, the RPI is quite general whereas other indices (such as the Index of Electrical and Optical Equipment, which is more specific to the IT sector) may be a truer reflection of cost changes in the industry. The price may also be subject to most favoured customer or market testing provisions.
One of the issues which a customer will have is the extent to which there is flexibility around the service charge if its requirements for the services reduce. For example, it might be that at the time the contract is signed, it covers desktop services and the customer has 1000 desktops. What if in four years’ time, due perhaps to an economic downturn or business process re-engineering, the customer has only 500 desktops to service. Should it be paying the same service charge for this level of service?
There may also be optional services which are priced at the same time as the service charge for the IT services as a whole is negotiated. This can provide an opportunity for the supplier to provide further services and for the customer to know the price at which they can be obtained. In the case of a public sector contract, these provisions would need to be kept within the EU Procurement Rules and, therefore, be a service incorporated in the original OJEC Notice which contained the call for competition.
It may also be the case that the contract will specify how the service charge is to be calculated for changes to the services agreed under the change control procedure. These could typically use some formula to arrive at a charge which is fair to the customer and provides a reasonable return to the supplier, probably with an open-book element so that the customer can see the breakdown of costs proposed for any change.
There may also be arrangements for charges which will be paid in the event of termination of the contract for various reasons and with reference to the supplier assisting the customer to move to another service provider.
Technology Refresh
Responsibility for changes in the technology, over the course of the agreement should be negotiated into the contract and represent a fair transfer of risk to the supplier. The contract should also recognise the reality that, although technology developments may drive down hardware costs, this is often balanced by increasingly complex and expensive software that entails higher specification hardware procurement.
When dealing with cutting-edge technology it is particularly difficult to set a technology refresh price at day one, as it is hard to say what the cost will be three years later. In a long-term contract. flexibility on the technology refresh price may be best. This can be achieved by setting out the assumptions on which the contract is entered into and including a mechanism for re-negotiating the price if, in the future, reality does not tally with the original assumptions. The contract should also reflect the fact that, when technology changes and new software is introduced, support demands often inevitably increase in the short term as users adapt to the new technology.
Open Book
One common practice is for customers, particularly in the public sector, to require an open-book approach to the contract where the supplier’s pricing model is included so that they can be sure that the basis for the service charge, including the supplier’s margins, are reasonably fair.
The Government lays down open-book accounting as a standard requirement. The aim of open-book accounting is to allow the customer to challenge both cost and profit. In practice, however, it is hard to assess the cost of administrative overheads, research and development etc and it is difficult to allocate costs of overheads that are shared between a number of customers. Open-book accounting also has an administrative cost in itself.
In practice, open-book accounting does not really drive price changes, as customers tend not to exercise their right very often. This probably reflects the fact that assessing the information received can involve complex financial analysis with differences of opinion on how to assess the results. For the same reason, price review mechanisms are not used as much as they could be.
Open-book accounting can be used perhaps more effectively in relation to change control provisions. Often a customer will be locked into a supplier, which during the term of the service contract is the only realistic provider of upgrades or enhancements required by the customer. The customer will be vulnerable to a supplier taking advantage of its position and charging excessively for such upgrades. Open-book pricing in this context requires the supplier to disclose all elements of the price including its profit margin and so provides the customer with a useful check.
Public Sector Contracts
The pricing provisions are of particular importance in public sector contracts where there are often very large and complex projects and it is taxpayers’ money that is at stake. There is always considerable pressure on Government spend and the number of high-profile failed projects highlighted by the National Audit Office and the Office of Government Commerce in recent years adds to the focus on pricing. Suppliers are also concerned with the high bid costs of projects, which are lost completely if they are not selected, and eat deeply into their margins if they are. They also need to be assured with the payments spread over a long period that they will nevertheless start to see a return reasonably quickly to keep their shareholders happy.
The public sector is becoming much more sophisticated in its approach to pricing models in IT service contracts. The Government will often require:
· details of the supplier’s profits to ensure they are fair
· a fixed cost per service
· open-book accounting
· benchmarking of the supplier’s prices to competitors’ prices
· a ratchet mechanism to pull back the supplier’s prices to ensure the supplier does not make excessive profits.
In contrast to this, industry obviously wants to keep the pricing structure as simple as possible and to make a fair return. The suppliers also require flexibility – it is difficult to tie everything down for 10 years in the changing world of IT.
Gain Sharing/Profit Sharing
Gain share represents a relatively new method of rewarding an external service provider by enabling it to participate in the savings that it makes for the customer. Profit share is the reverse where the customer is entitled to share in profits made by the supplier which are directly derived from work it has done for the customer. An example would be a royalty on further exploitation of intellectual property rights generated by the supplier in providing services to the customer.
IT contracts often provide for both gain sharing and profit sharing in tandem, yet the two do not sit well together. Each provides a mechanism where one party can share in any financial upside the other party may have. Yet where both are found in a contract, the effect may be counteractive as driving down costs triggers the gain share but will also paradoxically increase margin and trigger profit sharing. The interaction between these mechanisms requires careful thought or the supplier will have little incentive to decrease costs.
In practice neither profit share nor gain share can be meaningfully exercised in the early stages of a contract. Where profit sharing is included in a contract it also needs to operate on a cumulative aggregate basis (for example, where there are three years of loss followed by one year of profit, the one years’ profit should be offset against the preceding years’ losses).
It should be remembered that profit share or gain share rights may effectively remove the supplier’s incentive to increase service efficiency and curb innovation as the supplier ends up focussing all their efforts on the price of the service. Often this means that service levels do not move along with the times.
Monitoring and Managing the Relationship
Even after the contract has been signed, the service charge payment process should still be carefully monitored as a part of the management of the project so that the appropriate payments are made. Where this is done any issues or difficulties which perhaps were not foreseen during the original negotiations can be dealt with in a timely and effective manner before they give rise to any kind of dispute.
All too often both customer and supplier ‘forget’ about the contract once it has been signed and then only revert to it if and when the relationship between customer and supplier turns sour. It is better, in many ways, to use the contract to manage the relationship from the outset. It may be useful to provide for the customer to appoint a third party “contract manager”. The manager should then, ideally, manage the customer as hard as the supplier. Otherwise the customer can itself often fail to comply with the contract (eg a lack of attendance by the customer at a training session may be a breach of the contract and can also cause practical issues later on).
Conclusion
Price clauses and schedules are critical aspects of IT service contracts in the public and private sectors. They should not be dealt with in isolation but in conjunction with other aspects of the contract. Many parts of the contract are affected by the pricing provisions.
If the service charge is too high, the customer ultimately will not achieve the savings it wishes and will not be content with the arrangements. If it is too low, the supplier will be tempted to cut corners and service quality will suffer. Either way tends to lead to dissatisfaction, a breakdown in relations and renegotiation of the contract or possibly litigation if the parties cannot resolve their concerns. A balance is critical. A contract with a fair service charge and some flexibility about how it may increase is likely to encourage a higher standard of performance. All of this requires time and dedication by all involved in the preparation of the contract, but this will in the long term be outweighed by the benefits for both sides.
Clive Davies and David Carter are lawyers with the Media, Communications & Technology
