Contract Outsourcing – How To Formalize & Negotiate It?

What is an outsourcing contract?

An outsourcing contract stands as a legal agreement delineating the terms and conditions governing the relationship between a client and a service provider. This pivotal document encompasses crucial elements, including the scope of work, deliverables, timelines, quality standards, payment methods, dispute resolution mechanisms, and termination clauses. Serving as a guiding framework, the outsourcing contract directs both parties throughout the project and serves as a point of reference in the event of conflicts or disputes.

Nowadays, many companies opt for outsourcing as a means to accomplish various tasks without the need for permanent staff. This is where outsourcing contracts play a crucial role. If you’re new to outsourcing and considering IT services from countries like India, China, or Poland, you’re likely to wonder about the specifics of outsourcing contracts. Let’s explore what they entail.

In essence, outsourcing contracts are comprehensive legal documents that outline all the expectations of the outsourcing company. These contracts serve as agreements between the two parties involved in the outsourcing project: the vendor and the buyer. Beyond work expectations, the contracts cover essential aspects such as quality parameters, timelines, pricing, rewards, and more. Additionally, the contract addresses legal matters like intellectual property rights, non-disclosure agreements, and other relevant considerations.

In short, outsourcing contracts provide a detailed roadmap for a successful outsourcing partnership, ensuring both parties understand their roles and responsibilities throughout the process.

Key Objectives for a Successful Outsourcing Contract

To ensure a successful outsourcing contract, consider three key objectives:

• Clearly define the outsourced services and ensure their alignment with pertinent regulations and laws in your country.

  This fosters transparency and reduces future surprises, allowing both parties to evaluate the viability of the deal.

• Make sure all time frames are explicitly stated and subject to client demand, remaining open to potential change orders once work has commenced.

  Avoid making assumptions and maintain flexibility throughout the process.

• Both parties should mutually agree before any financial transactions occur.

  This shared acceptance ensures that everyone takes responsibility for their roles in the contract. In the event of issues arising later on, having a clear understanding from the outset can facilitate a smoother resolution.

Remember, outsourcing is a multifaceted process influenced by various factors, including the required services, project scope, and completion timelines. To determine the best approach for your specific needs, it’s highly advisable to seek guidance from an expert in the field. Reach out to an experienced professional today for valuable insights and assistance.

Essential Considerations for a Successful Outsourcing Contract

Here are the revised five points that describe what an outsourcing contract is:

Clear Boundaries: Avoiding Grey Zones

One of the most common sources of conflict in outsourcing is the lack of clarity about what is included and what is excluded from the scope of work. To avoid this, an outsourcing contract should clearly define the boundaries of the project, such as:

• The specific tasks and activities that the service provider will perform
• The deliverables and outcomes that the service provider will produce
• The resources and tools that the service provider will use
• The assumptions and dependencies that affect the project
• The exclusions and limitations that apply to the project

Targeted Key Performance Indicators (KPIs) for the CIO

Another key element of an outsourcing contract is the definition of key performance indicators (KPIs) that measure the quality and efficiency of the service provider’s work. KPIs should be:

• Relevant to the objectives and expectations of the project
• Specific and quantifiable
• Agreed upon by both parties
• Monitored and reported regularly
• Linked to incentives or penalties

Effective Governance Model: Maintaining Control

A third important aspect of an outsourcing contract is the establishment of a governance model that ensures effective communication, coordination, and oversight between the client and the service provider. A governance model should include:

• The roles and responsibilities of each party’s representatives
• The frequency and format of meetings and reports
• The escalation and resolution procedures for issues and risks
• The change management process for modifications to the contract
• The audit and review mechanisms for quality assurance

The governance model proposed by the provider is a critical aspect of the outsourcing contract. The CIO should focus on processes for overseeing the service, encompassing reporting and the ability to adapt to service changes. This involves defining procedures for scope and service evolution, handling volume variations (incidents and changes), and integrating new technology. Importantly, an outsourcing contract doesn’t equate to an exclusive partnership with a single provider; it should allow flexibility to work with other providers for specific tasks integrated later into the contract scope.

Exit Strategy: Planning for Contract Termination

A fourth essential aspect of an outsourcing contract is the provision of an exit strategy that outlines how the relationship will end when the contract expires or is terminated. An exit strategy should cover:

• The conditions and reasons for termination
• The notice period and procedures for termination
• The handover and transition process for deliverables and assets
• The settlement of outstanding payments and liabilities
• The post-contract obligations and rights of both parties

Recognize that an outsourcing contract has a defined duration, and circumstances may change. Discussing the exit plan from the contract’s inception is essential. This plan should address elements to be transitioned back to the client, knowledge transfers for potential re-insourcing, and collaboration models for transitioning to another provider. The exit plan should be an integral part of the outsourcing contract.

Balancing Control and Focus

A fifth critical aspect of an outsourcing contract is finding the right balance between control and focus. On one hand, the client needs to maintain enough control over the project to ensure its success. On the other hand, the client needs to allow enough focus for the service provider to perform its work efficiently. To achieve this balance, an outsourcing contract should:

• Avoid micromanaging or interfering with the service provider’s work methods
• Trust and respect the service provider’s expertise and experience
• Encourage collaboration and feedback between both parties
• Support innovation and improvement initiatives by the service provider
• Recognize and reward the service provider’s achievements

How to negotiate contract outsourcing?

Many companies consider outsourcing a wide range of business processes, including IT services, to achieve significant cost savings. While there are various ways to structure such agreements, a well-thought-out contractual arrangement with appropriate cost-sharing, pass-through mechanisms, and pricing adjustments allows both parties to share certain risks and establish a productive and profitable relationship.

International outsourcing agreements pose challenges for both the vendor and the customer. The vendor is often required to coordinate a worldwide rollout of services with limited time for proper business and legal due diligence before finalizing pricing and implementation. On the other hand, the customer faces potential risks to their performance, costs, and reputation by partnering with an external service provider. Therefore, both parties must carefully assess the perceived value proposition of outsourcing, which promises better and more reliable services at a reduced cost. However, in practice, while customers desire superior services at a lower price, vendors cannot assume liability for every business and legal risk.

In essence, successful outsourcing arrangements require a balanced approach, where risks are shared, and both parties collaborate to ensure a mutually beneficial outcome. Proper evaluation, clear communication, and well-defined contractual terms are essential in establishing a successful and enduring outsourcing partnership.

Scope of the Agreement

First and foremost, both parties must exercise caution to prevent issues related to pricing and the scope of services, commonly known as “scope creep.” In most cases, the vendor will establish a base price for services and apply separate adjustments and fees for additional services, such as per-project consulting. Therefore, during the early negotiation stages, both parties must have open and transparent discussions about the scope of services, particularly when the vendor intends to engage in subcontract negotiations.

For instance, in IT outsourcing agreements, if the customer requires ad hoc administrative services, it may be advantageous for the parties to explore a hybrid model involving fixed and variable fees. Furthermore, if the customer anticipates making adjustments to the scope of services at specific milestones, like an annual review based on usage patterns or in the event of a significant merger or acquisition, both parties should assess how the removal or addition of specific services impacts the overall financial margins. If the base service price combines low- and high-margin countries into a “blended rate,” eliminating high-margin services could substantially alter the contract’s value.

Structure of the Agreement

Structural challenges inherent in global contracts can have a profound impact on the relationship between the involved parties. An illustration of this is the need for a clear understanding of the mechanism for assessing compliance with service-level agreements, both on a per-country and global scale. To establish reasonable penalties in the form of credits or liquidated damages, the parties must grasp the significance of mission-critical performance standards and the implications of measuring performance through different approaches.

Likewise, when addressing payment-related issues, the parties should assess the potential impact of currency fluctuations on the contract. If the vendor compensates its employees or subcontractors in the local currency but invoices the customer in U.S. dollars, it becomes essential to determine who should assume the currency risk. In the broader context, any ambiguity in international outsourcing agreements can lead to inefficiencies and additional costs.

International Issues

The parties must also confront the demands of international law, encompassing intellectual property regulations and country-specific statutes. For instance, foreign labor laws could significantly complicate a customer’s plan to transfer employees to the vendor. In European Union countries, legislation established under the European Commission’s Acquired Rights Directive generally mandates that transferred employees receive the same or equivalent employment terms and benefits, including severance packages.

Likewise, regulations established under the European Commission’s Data Privacy Directive may restrict the transfer of personal data to non-EU countries unless specific additional notice, consent, and security criteria are met. Since U.S. privacy laws do not offer protection deemed adequate under the EU Data Privacy Directive, cross-border transfers involved in the outsourcing agreement may be restricted unless the parties take measures to meet additional EU standards. In such a scenario, the parties should consider negotiating mechanisms for cost-sharing or pricing adjustments on a per-country basis, particularly if the customer operates within a heavily regulated industry, such as banking, insurance, financial services, or medical services.

The intricacies of international outsourcing agreements necessitate a unique combination of business and legal expertise. By gaining a deeper understanding of these issues, companies can engage in negotiations to establish an appropriate contractual relationship and achieve the required cost savings.

How to formalize an outsourcing contract?

There are several procedures involved in drafting an outsourcing contract, and we will summarize the most common ones:

• Request-For-Proposal (RFP)

  The firm sends an RFP to a selected group of potential outsourcers, seeking information about their company, sector, activities to be outsourced, use of sub-suppliers, contract duration, and transfer of personnel.

• Specificity and Flexibility

  The contract must strike a balance between being specific enough to regulate key aspects and flexible enough to handle unforeseen events without conflicts arising.

• Performance Evaluation Criteria

  The contract should define the criteria for evaluating the outsourcer’s performance and specify the consequences if these criteria are not met. It may also address the use of sub-suppliers and dispute resolution through arbitration.

• Understanding Supplier Profit

  The firm must understand where and how the supplier earns a profit to negotiate effectively. Although pricing is not the only parameter for outsourcing, competitive supplier arrangements often lead to lower prices and reduced margins.

• Tactics to Win the Contract

  Potential outsourcers may use various tactics to win the contract, such as offering low prices for essential services and charging additional costs for contingency services. Suppliers might also initially lower prices and request price adjustments later or impose high withdrawal penalties to deter early contract termination.

• Comparative Analysis and Due Diligence

  Researchers suggest undertaking preventive due diligence for each phase of the outsourcing agreement, especially for offshore outsourcing, due to widespread controversies.

• Pilot Programs

  For the production of goods or service supply, pilot programs may be used, where a limited group of customers test the service under agreed standards. The supplier may offer the service at zero or low cost during the trial period.

• Transfer of Outsourced Functions

  A plan is agreed upon between the two core businesses, outlining the time frame and method for transferring the outsourced functions. Proper involvement of the outsourcer’s personnel and possibly a project team help manage the transfer. Complex activities require more time for a successful transition.

• Starting with Modest Impact

  Companies often begin by outsourcing a function with a limited impact on their economic results, aiming to reduce the negative impact if the performance falls short of expectations.

In conclusion, carefully structuring an outsourcing contract and considering various factors during the negotiation process is crucial for a successful outsourcing relationship. It involves evaluating risks, understanding pricing and profit dynamics, and effectively managing the transfer of functions.

Contract Outsourcing – examples and what should you focus on?

Services Rendered

One of the major areas your outsourcing contract needs to establish is what work is being done.

Again, this can be as simple as ‘design work.’ It depends on your need and what the third-party company is offering so you can develop a successful outsourcing relationship.

Sometimes this can get complicated if the Provider is doing a plethora of things for your business. However, you should always complete this section of the contract so that everyone is on the same page and in agreement with the work being done.

This section of the document usually comes right after the intro paragraph that establishes that this contract is between the buyer and seller of the service. It can be a simple table on the document that lists the work being done with a brief description of that work next to it.

From there, but in the same vein, you need to show what deliverables the company will be responsible for. This goes hand-in-hand with the services, though it is important to list everything out so that everyone agrees on the total result of the contract.

Payments

After you have listed out the services and deliverables, you should move on to how the third party will be paid. Are they getting lump sums throughout the work based on the deliverables? Are they under a retainer where you are paying them for X amount of work over X months where payments are rolled out based on time?

These are things that need to be explained in this section of the outsourcing contract.

In other words, this is an invoice area that shows what work was done, what rate it was done for, and what payments are sent out. Like everything else on this document, it largely depends on what you’ve negotiated with the third party.

We recommend making this section as easy to understand as possible so that you and the third-party provider are all on the same page, which can negate conflicts down the road.

However, the real legal part of the document comes next.

Terms and Conditions

This is the bread and butter of the document, legally speaking. Of all of the sections we’ve talked about already, this is where your lawyer will come into play the most because there are specific things that you need to say to protect your business when working with a contractor.

Since we are not lawyers, we will not go into the nitty-gritty details here. Instead, let’s look at a few things that are typically listed under the terms and conditions header:

• Retained Rights: This explains what pre-existing intellectual property each company has and dictates that those parties will keep all of the rights to their previously created intellectual property.
• Pre-existing Intellectual Property: This piggybacks off the first part, explaining what pre-existing intellectual property is, how it can be used, what it can’t be used for, etc.
• Deliverable Ownership: Who owns the deliverables when they are complete? Typically it’s mandated that the client owns all deliverables in the end.
• No Rights to Customer Intellectual Property: Basically, a way of saying that the third party will not retain any intellectual property from their clients even though the client will allow them to use this property to complete their contract.
• Confidential Information: This section describes what ‘confidential information is and how it can be used, how it is protected, and things of that nature. This section can have a staggering amount of legalese in it. After this, typical contracts move to ‘customer confidential information,’ which helps cover both parties – the contractor and contractee.
• Non-Disclosure: This covers how information can be doled out to the public and things of that nature… It also typically includes information on the right to disclose.
• Conflict of Interest Statement
• Termination and How It Works: This section is quite long, going over who can terminate the contract, when, how, and under what circumstances. Then, it moves on to say what the next steps are if the contract is terminated.
• Ensuring Provider Compliance: The final section has the Provider agree that they will not infringe upon patents and things of that nature, they will professionally complete the work, they will do the best work possible, they have all of the permits they need to complete the work, and they will comply will all laws in doing so.

As you can see, even the overview of this section is quite daunting, and we even left out all of the legal jargon.

Final Sections

After the terms and conditions, there are just a few other areas that need to be addressed, such as:

• Inspection and Acceptance
• Insurance
• Misc
• Such as governing law, severability, what an independent contractor is, and force majeure.
• Signature Area

Contract Outsourcing – Conclusion

When it comes to outsourcing contracts, you need to seriously cover your legal bases by explaining a bunch of things in detail. To pull this off, work closely with your lawyer, who can make this process extremely easy.

In short, your outsourcing contract needs to cover what work is being done, how much that work costs, when it’s due, and what the deliverables are. Other than that, it’s mainly terms and conditions that are pretty standard in any contract, legally speaking.

Before finalizing a contract for outsourcing services, both the outsourcing service provider and the outsourcing service buyer must engage in negotiations. It is recommended to create a preliminary contract outline, allowing room for discussions and adjustments. Once the negotiations are complete and the initial draft is thoroughly reviewed, proceed to craft the final version of your outsourcing contract.

During the process of developing your outsourcing contract or IT outsourcing agreement, it is crucial to include all pertinent details comprehensively to prevent misunderstandings or omissions. A well-crafted outsourcing contract often serves as the cornerstone of a successful outsourcing venture.

Remember, meticulous attention to detail and thorough negotiations will ensure a smooth and beneficial outsourcing partnership.

Common questions

Why renegotiate an outsourcing contract?

If you are considering renegotiating your outsourcing relationship, you are not alone. Renegotiations of outsourcing contracts are increasingly common, with approximately 75% of existing outsourcing relationships being renegotiated at some point during their lifetime. Contrary to what some may think, renegotiations can occur for positive reasons, and they can be initiated by either the service provider or the client.

Change can be beneficial, and if the current outsourcing contract no longer aligns with your evolving circumstances, there is no need to wait for the contract to expire. Taking a proactive approach to renegotiating your outsourcing relationship can lead to improved outcomes for all parties involved.

Here are seven reasons why you should consider renegotiating your outsourcing relationship:

1. Adapting to Changing Circumstances: If your business needs, requirements, or goals have evolved, renegotiating the contract can ensure it aligns with your current situation.
2. Positive Partnership Improvements: Renegotiations can lead to positive changes that enhance the partnership’s effectiveness and success.
3. Easier and Less Risky Than Exiting: Renegotiating the contract is often a more feasible and less risky option than completely terminating the outsourcing arrangement.
4. Improving Vendor Governance: Clear communication and effective governance are vital for successful outsourcing partnerships. Renegotiations can address any breakdown in governance processes.
5. Enhancing Vendor Performance: If the vendor’s performance is lacking, renegotiating the contract can motivate improvements and avoid a breakdown in trust.
6. Win/Win Relationships: Successful partnerships are based on win/win relationships. Entering negotiations with a collaborative mindset is crucial for achieving beneficial outcomes.
7. Time for a Successful Conclusion: Renegotiations require time for thoughtful consideration and should be given sufficient breathing space to reach a successful outcome.

What are the three types of outsourcing contracts?

Understanding the various types of outsourcing contracts is crucial for any outsourcing venture. Let’s explore two prevalent types:

1. Time & Material Outsourcing Contract: This model is ideal for long-term software development projects where it is challenging to estimate time and costs upfront. The contract is based on the required IT services or products and the time taken to complete them. It offers flexibility and continues until the client’s requirements are fulfilled.

Suitable for:

• Projects requiring flexibility and without clearly defined scopes.
• Projects with innovative or complex concepts.
• Projects needing emerging technologies for completion.
• Clients seeking control while collaborating with external teams.

2. Fixed Price/Managed Project Outsourcing Contracts: In this model, the outsourcing company bids on a Request For Proposal (RFP) with a fixed cost for specified services. The contract is well-suited for projects with clearly defined requirements and predetermined costs. It minimizes flexibility but ensures project management and timely delivery.

Suitable for:

• Projects with well-defined and clear requirements.
• Projects with shorter timelines.
• Projects not expected to undergo significant changes post-completion.
• Clients comfortable with relinquishing control under managed projects.

Understanding these contract types will help you select the most appropriate one for your outsourcing needs, whether a flexible time & material contract or a well-defined fixed-price contract for managed projects.

Which of the risks of outsourcing are associated with contract lengths?

Outsourcing offers significant benefits but also comes with risks. Some risks, like currency fluctuations, can be addressed through financial-hedging strategies in contracts. However, other risks are harder to anticipate and manage.

The riskiest functions to outsource are those that can disrupt the product or service flow to customers. For instance, outsourcing distribution to an online retailer may lead to delayed deliveries and dissatisfied customers. Outsourcing call center responsibilities can result in customer complaints and harm the company’s reputation.

The second riskiest type of activity to outsource involves the relationship between the company and its employees. Outsourcing HR functions may impact employee hiring quality, and outsourcing payroll can lead to data breaches and legal issues. Outsourcing software design might hinder organizational innovation.

To mitigate uncertainties, flexibility should be incorporated into outsourcing contracts. One-year reviews and short-term contracts can be costly, and contract variation clauses may not cover all uncertainties. Paying for flexibility may be preferable to rigid performance contracts with penalty clauses that could lead to litigation.

Inevitable uncertainties should be addressed through a conflict resolution process in the contract. Companies may prefer to control their destiny in situations where uncertainties are likely to arise. Educating companies about the uncertainties in IT contracts can lead to better problem-solving rather than resorting to legal actions. Ultimately, the goal should be to find solutions to contractual problems rather than seeking litigation.

How can misunderstandings be prevented in an outsourcing contract?

Prevent misunderstandings by incorporating all pertinent details comprehensively during the contract development phase. Thorough negotiations and meticulous attention to detail further contribute to clarity and understanding.

How to choose a reliable contract outsourcing provider?

To choose a reliable contract outsourcing provider, you should consider the following factors:

• Experience and track record: Look for a provider that has successfully delivered similar projects in your industry and domain. Check their portfolio, case studies, and references to verify their quality and reputation.
• Values and culture: Find a provider that shares your vision, mission, and values. Make sure they have a compatible work ethic, communication style, and project management approach. You can also visit their facility or arrange personal meetings to get a better sense of their culture.
• Talent and technology: Evaluate the skills, qualifications, and certifications of the provider’s team. Ensure they have the expertise and tools to meet your technical requirements and standards. You can also ask for a trial period or a proof of concept to test their capabilities.
• Infrastructure and security: Assess the provider’s physical and digital infrastructure. Make sure they have adequate equipment, bandwidth, backup, and disaster recovery systems. Also, check their security policies, procedures, and certifications to protect your data and intellectual property.
• Flexibility and scalability: Choose a provider that can adapt to your changing needs and expectations. Look for a provider that offers different hiring models, such as full outsourcing or staff augmentation. Also, check their ability to scale up or down the team size and resources as per your project demands.

One of the providers that meets these criteria is Multishoring, the largest organization of nearshore IT consultants in Poland. Multishoring offers a smart IT delivery solution that combines the benefits of nearshoring and offshoring.