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How to formalize & negotiate the outsourcing contract?

23 February 2022
min read

Summary:

An outsourcing contract is a legal document that contains all the terms of what you expect from an outsourced company. The governance model in an outsourcing contract is essential to pay attention to, especially for how the Provider will respond if something changes.

The best way to prevent a company from being stuck in a contract with an outsourced provider is to have the exit plan integrated into the initial contract. Companies can save money by outsourcing work, but there are challenges on both sides.

A successful outsourcing contract should have three aims and objectives.

  • The first is to clearly define the outsourced services and what they will involve in terms of regulations or laws surrounding these activities from your country’s perspective. There are no surprises for either party involved in deciding whether or not this deal makes sense going forward.
  • Secondly, ensure everything explicitly related to time frames dependant on client demand, including any possible change orders once work has already started – never assume anything!
  • Finally, make sure both parties agree to upfront before any money changes hands as acceptance means responsibility. Hopefully, if things go wrong down the line, somebody knows a way out without too much trouble, but at least everyone was clear.

It’s important to remember that outsourcing is not a cut-and-dry process. There are many factors at play, from the type of service required, project scope, time frame for completion, etc. The best way to find out what will work for you is by getting in touch with an expert who can help guide you through this complicated world. Reach out today!

 

What is an outsourcing contract?

Nowadays more companies use outsourcing as a way to have done all the tasks they need in order to function, but without hiring permanent personal, this is where outsourcing contracts come into action. If you are new to outsourcing and are planning to outsource IT services to India, China, Poland, or any other country, this question is bound to enter your mind. Let’s decode what outsourcing contracts are.

In the simplest terms, outsourcing contracts are nothing but legal documents containing every detail of what you are expecting from the outsourcing company. 

It is an agreement signed upon by the companies getting into outsourcing projects – the vendor and the buyer. Not just the work expectations, it also contains information and details regarding the quality parameters, timelines, pricing, rewards, etc., of the outsourcing arrangement that the two parties are getting into. In addition to that, the contract also consists the legal issues around intellectual property, NDA agreement, and much more. 

Here we show you five clear points that describe best what an outsourcing contract is:

Avoid grey zones

Grey zones represent the significant risk of an outsourcing contract. Grey zones mean that both the service provider and the client don’t manage a specific activity or asset, which could increase the risks.

To avoid the grey zones, it is essential to list all activities/assets that are not in the scope of the outsourcing contract. In addition, a grey zone list must be maintained during the transition to acting who will handle each listed activity. The aim is to remove all points from this list as soon as possible.

Key Performance Indicators – The service objectives for the CIO

Do not fall into the trap of defining generic KPIs that would not represent the reality of the service to be delivered. The KPIs must represent the service objectives that the CIO has defined, and the Provider has committed. In addition, KPIs must not be limited to criteria like availability measures (the well-known 99,99% availability). Still, they must also integrate standards based on the relationship with the Provider to make the outsourcing contract an added value for the entire business through reactivity, improvement, innovation.

Governance model – Outsourcing contract does not mean you lose control!

A critical part of the outsourcing contract is the governance model that the Provider will put in place. The CIO must pay special attention to the proposed process to govern the service. It includes, of course, the services reporting but more than that, how to react in case of evolution of the services. Namely, you have to define the processes for scope evolution, services evolution, change in volumes (incidents, changes), and introduction of new technology. In addition, an outsourcing contract does not mean you are blocked with the Provider for all projects. The agreement must cover working when another provider is doing a task integrated later in the contract scope.

A contract has a defined duration – Think about the exit plan.

When the CIO is signing an outsourcing contract, he is convinced that the Provider is the right one. However, things can change with time, and the company strategy can evolve. Therefore, from the establishment of the contract, the exit must be discussed. What are the elements that will be transferred back to the client? What are the knowledge transfers that will be provided in case of re-insourcing? What are the collaboration models to move to another provider? The exit plan must be an integrated part of the outsourcing contract.

According to us, these five points are the key elements to consider when signing an outsourcing contract for the CIO to focus on strategic business initiatives while keeping control of the IT environment.

How to negotiate outsourcing contract – professional advice

To achieve critical cost savings, any company has considered outsourcing a broad range of business processes, including IT services. Although this kind of agreement can be structured in many ways, a thoughtful contractual arrangement, with appropriate cost-sharing, pass-through mechanisms, and pricing adjustments, allows the parties to share certain risks and, at the same time, establish a productive and profitable relationship.

International outsourcing agreements present challenges to both the vendor and the customer. Typically, the vendor will be asked to coordinate a staged, worldwide rollout of services with little time to perform adequate business and legal due diligence before pricing, much less rolling out the benefits. On the other hand, the customer will face the risks to their performance, costs, and reputation of partnering with a service provider. Thus, both parties must carefully evaluate the ostensible value proposition of outsourcing: a better, more reliable product at a lower cost. Practically speaking, as much as the customer wants superior services at a lower price, the vendor can’t act as the insurer of every business and legal risk.

Scope of the Agreement

First and foremost, both parties should be careful to avoid problems with pricing and scope of services — or, as it’s more commonly described, “scope creep.” In most circumstances, the vendor will charge a base price for services and use separate adjustments and fees for additional services, such as per-project consulting. Thus, early in negotiations, the parties should openly and honestly discuss the scope of services, especially if the vendor plans to negotiate subcontracts.

 

For example, in IT outsourcing agreements, if the customer wants ad hoc administrative services, it may be preferable for the parties to negotiate a hybrid model of fixed and variable fees. In addition, if the customer needs to adjust the scope of services at certain milestones (for example, annual review based on usage patterns or upon a significant merger or acquisition), both parties should consider how the elimination or addition of certain services affects the margins. If the price for base services combined low- and high-margin countries into a “blended rate,” eliminating high-margin services could significantly change the value of the contract.

Structure of the Agreement

At the same time, structural problems associated with global contracts can significantly affect the relationship between the parties. For example, the mechanism for measuring compliance with service-level agreements per country or global must be clearly understood. To provide for reasonable penalties in the form of credits or liquidated damages, the parties must realize the mission-critical performance standards and the effect of measuring performance in different ways.

Similarly, when addressing payment issues, the parties should examine how fluctuations in the currency will influence the contract. If the vendor pays its employees or subcontractors in local currency and invoices the customer in U.S. dollars, the parties must determine who should bear this currency risk. In the big picture, any ambiguity in international outsourcing agreements will lead to inefficiency and extra costs.

International Issues

The parties must also address the requirements of international law, including intellectual property laws and other country-specific rules and regulations. For instance, foreign labor laws could greatly complicate a customer’s plan to transfer employees to the vendor. In European Union countries, legislation enacted under the European Commission’s Acquired Rights Directive generally provides that transferred employees be given the same or comparable employment terms and benefits, including severance packages.

Similarly, legislation enacted under the European Commission’s Data Privacy Directive could prohibit the transfer of personal data to non-EU countries unless particular additional notice, consent, and security requirements are satisfied. Because U.S. privacy laws don’t provide protection that’s judged adequate under the EU Data Privacy Directive, cross-border transfers involved in the outsourcing agreement will be prohibited unless the parties take steps to satisfy additional EU standards. In this situation, the parties should negotiate cost-sharing or pricing adjustment mechanisms on a per-country basis, especially if the customer does business in a heavily regulated industry such as banking, insurance, financial services, or medical services.

The complexity of international outsourcing agreements requires a unique blend of business and legal expertise. By better understanding the issues, companies can negotiate an appropriate contractual relationship and achieve necessary cost savings.

 

How to formalize an outsourcing contract?

There are different procedures for drawing up the contract, the most frequent of which we will now summarize.

After having chosen a group of potential outsourcers, the firm sends each a “Request-For-Proposal” (RFP), in which some information is requested as information on the firm and sector, activities to outsource, recourse to sub-suppliers, length of the contract, transfer of personnel (Bragg, 2006).

The information obtained from the RFP is only the starting point for selecting the outsourcer and stipulation of the contract. The contract must be specific enough to regulate every key aspect and, at the same time, flexible enough to allow the parties to face the consequences of unforeseen events without conflicts arising.

In particular, the contract must define the performance evaluation criteria and what will occur if these criteria are not fulfilled. It must establish whether or not the supplier can, in turn, use sub-suppliers. Many contracts provide for arbitration to resolve disputes.

To effectively start the negotiation, the firm must understand where and to what extent the supplier earns a profit. Even if the fundamental parameter for outsourcing is not pricing, if the competition among suppliers is effectively arranged, then the prices offered are low and the margins reduced.

There are various tactics potential outsourcers can adopt to win the contract. Frequently the agreement contains only those clauses relating to the essential services in the platform of basic services. Additional costs are incurred for each contingency service not included in the medium. The firm responds by trying to broaden the platform and clearly defining the prices for the contingency services.

At other times the supplier renounces profits for an initial period, offering modest prices, only to ask for price adjustments later on when the outsourced has reduced its capacity to backsource, having given up carrying out the outsourced activities. The supplier imposes high withdrawal penalties to make it less convenient for the outsourcer to rescind the contract. The outsourcer, in turn, can respond by setting short-term contracts with low penalties for an early departure.

Arjun and Subhajit, after demonstrating how widespread and serious the controversies are, especially in offshore outsourcing, present the results of a comparative analysis of the procedures adopted by a sampling of firms to evaluate risks and of the policies adopted to select the offshore partners. Moreover, the authors recommend undertaking preventive due diligence for each phase of an outsourcing agreement.

When the outsourcing vendor concerns the production of goods or the supply of services, firms often turn to pilot programs, where the supplier identifies a limited group of customers and agrees on a period – which can vary from 30 to 90 days – during which the customers use the service according to the agreed-upon standards. The supplier that wishes to purchase the services to give back in outsourcing generally supplies the services during this trial period at zero cost or a very low cost. 

A plan agreed upon by the two core business – linked to the outsourcing contract – establishes the time frame and mode for the transfer of the outsourced functions. The preliminary information for the outsourcer’s personnel and the latter’s involvement is important in this phase. Often there is recourse to a project team whose aim is to manage the transfer.

For simple activities, such as maintenance, the transition can be swift. However, this is not the case for complex activities. Too fast or hurried a transfer may not allow the outsourcer sufficient time to learn about the activity to transfer thoroughly.

The firm that turns to outsource generally starts by outsourcing a function (or part of a function) that has a modest impact on its economic results on the organization to reduce the negative impact of performances that do not meet expected.

 

Outsourcing contract example

Outsourcing Contracts: Services Rendered

One of the major areas your outsourcing contract needs to establish is what work is actually 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 make sure to 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 end result of the contract.

Outsourcing Contracts: 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 over the course of 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.

Outsourcing Contracts: Terms and Conditions

This is really 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 in order 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 basically 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 complete the work in a professional manner, 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.

 

Outsourcing Contracts: 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

Outsourcing Contracts: The Final Say

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.

 

FAQ

Why renegotiate an outsourcing contract?

If you are looking to renegotiate your outsourcing relationship, you are not alone: Outsourcing contract renegotiations are on the rise.

According to Gartner Research around 75% of all existing outsourcing relationships are renegotiated at some point during their lifetime.  And contrary to what you might think, not all of these renegotiations are down to bad performance — contracts can be renegotiated for many positive reasons. Not only that but contract renegotiation can be triggered either by the service provider or the client.

The fact is this: change can be good. If the outsourcing contract is not aligning with your changing circumstances (for whatever reason), there is no need to wait for the contract to expire to implement change. Taking a proactive approach to your outsourcing relationship can make a huge difference to the efficacy of the outsourced service and result in improved outcomes for all parties involved.

With the above in mind, in this post, I want to cover seven reasons why you should renegotiate your outsourcing relationship. If any of these resonate with you, then it may well be time to take stock of your current situation and give serious thought to renegotiation. (Please Note: public sector organizations may need to consider a new procurement exercise if a variation is seen as being a material contractual amendment.)

Under all circumstances, if you are going to renegotiate your outsourcing relationship, you must keep one key thing in mind: successful partnerships are borne out of win/win relationships. If you enter negotiations with the intention of squeezing everything you possibly can out of the vendor, then you are highly unlikely to reach a beneficial outcome.

Furthermore, any renegotiation should be given plenty of time to reach a successful conclusion (or otherwise). The process can take some time, and you want to give yourself plenty of breathing space should you need to re-tender.

Because It’s Easier, Cheaper, and Less Risky than Exiting

Although at BPG, we have plenty of experience in helping organizations exit poorly performing outsourcing relationships, it is always the last resort. Even if a client comes to us with their heart set on exit, our first step will always be to carefully evaluate the existing partnership in order to ascertain if there is any chance of improvement. On multiple occasions, we have been able to address key issues and turn the relationship into one that both parties are happy with.

To Improve Vendor Governance Processes

In our experience, outsourcing partnerships often fail due to a breakdown in communication and/or management (i.e., governance). The administrative overlap between client and vendor is a real hot spot for outsourcing issues. Outlining how the two parties work together is as important as stipulating what business outcomes you want from the vendor — there need to be high levels of commercial trust and open communication between the two parties.

To Improve the Performance of the Vendor

Poor performance on the part of the vendor can quickly lead to a client’s lack of faith in them being able to deliver outcomes. That mindset is toxic to the potential success of an outsourcing relationship and must be avoided at all costs. The fact is that if you renegotiate your outsourcing relationship, it can make all the difference between failure and superb performance.

What are the three types of outsourcing contracts?

Once you know what an outsourcing contract is and why you need it for any outsourcing venture, it is now time that you understand the different types of contracts when outsourcing product development that are prevalent in the market and which one would be suitable for you. Without further ado, let’s start reading about the different types of outsourcing contracts:

Time & Material Outsourcing Contract

Let’s start with one of the most popular and the oldest outsourcing models- the time & material outsourcing model. This model is used when the software development project is a long-term one and an estimate of the time required, or costs cannot be made in advance. No prior estimation of the outsourcing cost can be made in this type of outsourcing contract and model, and it works on the basis of the IT services or product required and the time taken to complete it.

This is one of the popular types of an outsourcing contracts that adds to the flexibility and makes it seamless to complete projects that require a long time. The time & material contract ends only when the requirements of the client are fulfilled as the final delivery.

When Should You Form Time & Material Outsourcing Contract?

  • When flexibility is the core requirement of the project
  • When defining the scope of the project is not possible due to its complex & raw concept
  • When emerging technologies are required for your project’s completion
  • When the idea is too innovative to make advanced estimations
  • When you still want control over your project while having external teamwork on it

 

Fixed Price/Managed Project Outsourcing Contracts

Another popular outsourcing agreement form is the fixed price outsourcing contract. In this form, the company outsourcing IT services to India or any other country creates a Request For Proposal or RFP, and the outsourcing company places a bid on the same. 

It is like a managed project, and your requirements are clearly mentioned beforehand in the RFP along with the estimated costs. As the name suggests, it has a fixed cost that is to be paid for a particular type of service taken. The fixed cost outsourcing contract minimizes flexibility or your involvement in the project scope. This is one of the most commonly used types of outsourcing contract majorly used for IT outsourcing services. 

The outsourcing company usually has a project manager who takes care of the project and ensures that the product is delivered within the committed time and the cost decided upon. The only requirement in such projects is that you should have a clear view of what you want from the project and mention it clearly beforehand.

When Should You Form a Fixed Price Outsourcing Contract?

  • When you know exactly what you require and are able to describe it to the outsourcing company as well
  • When the project work requires a smaller time frame to complete
  • When you know that the project is simple and not many changes would be required once it is completed
  • When you are not worried about handling the control over to the company with the managed project approach

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

Outsourcing can have significant benefits but is not without risk. Raiborn, Butler, and Massoud (2009) Some risks, such as potentially higher offshoring costs due to the eroding value of the U.S. dollar, can be anticipated and addressed through contracts by employing financial-hedging strategies. Others, however, are harder to anticipate or deal with.

As a general principle, functions that have the potential to “interrupt” the flow of product or service between a company and its customers are the riskiest to outsource. For example, delegating control of the distribution process to an online retailer can result in customers not receiving goods promptly; Outsourcing call-center responsibilities can result in customers being dissatisfied with the product or service and, thus, in higher product returns, lower repurchases, or complaints that could endanger the company’s reputation.

The second riskiest type of activity to outsource is one that affects the relationship between a company and its employees. Outsourcing the human resources function, for example, can affect employee-hiring quality; outsourcing payroll and benefits processing can result in information breaches that generate identity theft issues and resultant legal issues, or outsourcing software design can generate a decline in organizational innovation. By contrast, support functions such as accounts payable and maintenance are less risky to outsource because they have few direct links to customers or internal organizational processes.

IT operations and development have always been inherently uncertain. Users are not sure of their needs, new technology is risky, business requirements change, and implementation is full of surprises. A systems project management regime that demands no changes to specifications and rigid time and budget controls can produce applications that do not achieve their full potential or can create user-specialist conflicts. Companies should avoid outsourcing contracts that are set in concrete. As a result, there is plenty of advice in the outsourcing literature to build in contract variation clauses, agree on annual reviews, short-term sign contracts, and so on — if the vendors will agree.

In reality, one-year reviews can involve costly annual contract amendments. Short-term contracts may attract cost premiums, and contract variation clauses may not foresee all the uncertainties. An executive at an airline that both supplies and buys services reflected on this dilemma: “You can buy flexibility, but you have to pay for it.” A U.S. food company discovered that the development of new systems was going to take longer than expected, as business requirements were changing. It had outsourced the running of the legacy applications that the new systems were replacing. The food company approached the vendor to seek a nonpunitive revision of the contract. The vendor’s reply was the equivalent of caveat emptor, or “we knew what we were signing, even if you didn’t.”

Being willing to pay for flexibility may be better than specifying tight performance contracts with penalty clauses, followed by litigation. A lawyer in this field remarked that he was happy to take legal fees from clients who believed that IT was a game of certainty and discovered that it was not, but he would prefer to earn money by educating them. His first principle was that when they met contractual problems in IT, companies really should want to solve them, not sue the third party. Thus IT contracts of any sort should first agree on a process of conflict resolution and problem solution for the inevitable uncertainties. However, the more likely it is that uncertainties will materialize, the more a company might wish to control its own destiny.

 

A final note

Before you form a contract for outsourcing services, there would be negotiation on the parts of both the outsourcing service provider a well as the outsourcing service buyer. Create a skeleton contract first and leave the scope for negotiations. Once the negotiations are done post-reading the first draft, you should get on to forming the final draft of your outsourcing contract.

While you are forming your outsourcing contract or IT outsourcing agreement, the first thing that you should keep in mind is to include everything in complete detail to avoid any type of misunderstanding or missing out of information. A well-drafted outsourcing contract, in many cases, might be the key to a fruitful outsourcing venture.

 

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