For lawyers specializing in outsourcing transactions, it is by now a truism that one of the most challenging aspects of the transaction is the need to provide for change during what can be a very lengthy term. Outsourcing contracts may run for a period of seven to ten years, or more; to put that time period in perspective, some outsourcing arrangements, in particular those with a significant development (or "build and implement" component), can take more than a year before the services component even commences — and even in that limited time period, significant changes can take place. These changes may result from internal developments (for example, a merger, divestiture or other corporate reorganization, or refocusing of the customer’s business) or external developments (for example, the introduction of a competing product or service on the market).
The need for an outsourcing arrangement to be able to respond to change impacts different elements of the agreement. For example, the trend towards slightly shorter terms (e.g., five to seven years) has been interpreted as at least partially reflecting an acknowledgment of the relative importance of the flexibility provided by a shorter term, over the certainty of having the arrangement continue for a few more years. Governance arrangements, benchmarking, change control mechanisms, provisions allowing for strategic change in the customer’s direction — all of these elements can also assist in managing change throughout the term of an outsourcing arrangement. One the most important mechanisms to assist in responding to change, however, is that of pricing.
This chapter will provide an overview of how pricing mechanisms in an outsourcing arrangement can be structured to respond to change.1 We begin by reviewing how pricing can respond to changes that can occur during the development and implementation phase, if any, of an out-sourcing arrangement — more specifically, changes in business requirements, and extraordinary changes in costs. We then examine changes that can occur during the services phase of an outsourcing arrangement — in particular, changes in services demand, changes in the scope of services, changes in the cost base as the services mature, changes in the applicable regulatory framework, and changes in the base assumptions (i.e.,"extraordinary events"). We conclude by emphasizing the importance to both the customer and the service provider of designing a certain degree of pricing flexibility into the outsourcing arrangement.
PRICING DURING DEVELOPMENT AND IMPLEMENTATION
Changes in Business Requirements
Outsourcing arrangements which begin with a significant development and implementation component at the front end can raise their own pricing complexities. In a perfect world, the parties will settle the business requirements, such that the customer and the vendor know the pricing and scope of work respectively, prior to the date of execution. In practice, however, there will be changes to these base requirements subsequent to execution, whether required by the customer (for example, to reflect the existence of a new competitor or new functionality on the market) or the vendor (for example, to reflect any limitations of the vendor). Such changes against the base requirements will likely need to be managed through the change control process. A more difficult case, however, is raised where the base requirements are not settled by the date of execution. Detailed business requirements for a complex systems development can take months for the customer to develop, and additional months for the service provider to review, and in most cases trim back, this customer "wish list". As a result, the parties may execute the agreement prior to these requirements being finalized. This can present challenges in that effectively the baseline scope against which "change" will be measured will not yet have been finalized. In this circumstance, the service provider will want to minimize "requirements creep" (effectively a form of "scope creep") post-execution and/or adjust the pricing to reflect the "additional" requirements, while in contrast the customer will want to ensure that the development for which it is paying includes all of the required elements without any material increase in the price.
How, then, can counsel best structure the outsourcing agreement to address that uncertainty in advance? Simply passing off the issue to change control is insufficient; rather, counsel should seek to provide the parties with some guidance, in the form of a process combined with interpretative principles: that is, if possible, the parties should seek to settle at least the initial base list of business requirements prior to execution, and then refer to a set of enumerated principles to determine whether an addition to this list is in-or out-of-scope.2 These principles could include:
- that no final list of business requirements should materially diverge from the initial requirements, other than where there has been a material change in the assumptions underlying same;
- that where the new system is replacing a legacy system, and the customer requests that some of the existing functionality be included, there should be a presumption in favour of including same in the requirements;
- that the objectives of the outsourcing, which may be stated at the beginning of the outsourcing agreement, should be considered in making the determination;
- that any systems and related services required to provide the outsourcing services subsequent to the build should be deemed to be included in the requirements; and
- that secondary materials, such as the RFI and the RFP, if applicable, and the service provider’s respective responses to same, may also serve as a useful gauge as to the parties’ intent regarding the business requirements.
Extraordinary Changes in Costs
Value-Based vs. Cost-Plus Pricing
Service providers will often favour value-based pricing, wherein the pricing is intended to reflect the inherent value of the deliverable, rather than cost-plus pricing, where the customer pays the service provider’s costs (including overhead) plus a specified profit. This latter pricing model can either be less transparent, wherein the customer has an approximate idea of the costs of the vendor and an appropriate profit margin, or more transparent, wherein the allowable costs are specified, overhead is calculated according to a fixed formula and the customer is provided sufficient audit rights to verify all allowable costs. As a note, service providers are often reluctant to agree to transparent cost-plus pricing because they are reluctant to disclose their costs.
Cost-plus pricing models are only infrequently used for the entire outsourcing arrangement, but are more commonly used for certain portions of the services. For example, value-based pricing may be appropriate for the development of the key deliverables, which may have the inherent value to justify said pricing model, but may not be appropriate for less high-value services such as maintenance and support.
Value-based pricing can present certain challenges for the customer. While a service provider may argue that such pricing effectively reflects the market value of the applicable service, for a new product or service there may not be a competing provider such that a true "market" exists; rather, the market — at least in the short term — may reflect to a certain degree the characteristics of a monopoly. Benchmarking during the term of the agreement can be a particularly useful tool in this circumstance, by allowing the customer to compare the pricing of competitors as they emerge in the market.
However, value-based pricing can also impose disadvantages on the service provider. For example, it is difficult for a service provider faced with an unforeseen increase in its costs to successfully appeal to the customer for relief — that is, for an increase in fees to reflect such increased costs — where the pricing is not based on a cost-plus model. Crudely put, if the service provider is benefiting from the upside of higher margin value-based pricing, it may be difficult to argue that the customer should be sharing in the downside of the risks of cost increases. Also, if a significant component of the "value" is premised on having exclusive use of the system for a period, whether contractually imposed or de facto due to the time required for the service provider to roll out the system for other new customers, then the customer may argue that this value model becomes increasingly less relevant as others also begin to benefit from the product or service, and thus the pricing should decrease over time to reflect this decrease in value.
Pricing Adjustments Where Increase in Service Provider Base Costs
As noted above, a service provider may seek to include a pricing mechanism in the outsourcing agreement which allows the service provider to request an increase in the fees where actual costs exceeded agreed budgeted costs by a specified percentage (the assumption being that any increase which is less than such a percentage is an ordinary course increase, the risk of which the service provider should shoulder). Should a customer agree to such a mechanism, it will likely seek reciprocal protection allowing for a decrease in fees where costs are less than the agreed budgeted costs by, again, a specified percentage.
Note that the customer:
- will have to make the assessment as to whether this actually provides real reciprocity for the customer — that is, whether in the context there is a realistic and/or proportionate possibility that budgeted costs could go down by more than the specified percentage;
- may want to ensure that the quantum of the adjustment in fees also reflects a risk-sharing, such that the fee adjustment passes on to the customer a specified percentage, rather than the total amount of, such increase;
- may make such adjustment conditional on the service provider committing to reduce those resources for which costs are increasing, to the extent such costs are variable and such reduction would not adversely affect the services; and
- may require that, in consideration of providing such latitude, the service provider provide a partial or full credit back of the amount of the increase, which credits could be used against future development and/or service fees.
Note that where there exists such a risk of cost increases and the agreement does not provide for such fee adjustment, the service provider will, to the extent possible, seek to build a contingency amount up front into their fees to insure against this risk.
PRICING DURING THE SERVICES PHASE
Pricing during the servicing phase of the outsourcing arrangement will be reflective of two competing dynamics. The customer will seek to have the same degree of flexibility to respond to change as it perceived that it had prior to the outsourcing, while the service provider will need a level of certainty to ensure that change does not adversely affect the business case of the service provider.
Changes in Service Demand: Volume-Based Pricing
A detailed review of base pricing options for outsourcing arrangements is beyond the scope of this chapter. However, it is important to note that the pricing mechanism for the base fee itself can be structured to reflect changes in the demand for or volumes of the particular services.
Different outsourcing arrangements will have different fee structures. Some will be based on a fixed price, for maximum certainty but minimum flexibility. Others will be based on a rate-based price which, while it permits the customer to more closely match cost with service volume, can also lead to too great an uncertainty for both the customer and the service provider. The service provider will often endeavour to mitigate this uncertainty through including a minimum annual total charge, or a variable unit fee which increases as the volume of units decreases; the customer, in contrast, will seek to include a maximum total charge, and a variable unit fee that decreases as the volume of units increases.
An alternative model bases the price on an annually forecasted number of units of services, which allows the service provider to specifically plan for the resources required to meet that forecasted amount. If the actual consumption exceeds that baseline forecast by a certain volume, however, the customer will be charged an additional resource charge ("ARC") for each unit by which such actual consumption exceeds the baseline. Similarly, where actual consumption is less than the baseline, the customer can receive a reduced resource credit ("RRC") for each unit less than the baseline. Different ARC rates or RRC rates might apply within different ranges or bands, depending on the degree to which the actual consumption is greater than or less than the baseline.
A customer with varying volumes may also seek to increase pricing responsiveness to changes in volumes by increasing the variable component of each rate (for example, labour costs, to the extent that they may be fungible) so that to the extent possible the service provider is required to reduce these components such that the customer is only paying for resources actually used. This will lead to a discussion regarding what costs for the service provider are truly "variable"; for example, while some labour costs may be variable where demand is cyclical and the job function is relatively low skill, other labour costs may not be variable, for example, where there is a labour shortage with respect to that particular skill level in the market.
Changes in Scope of Services
Reduction in Services
From the perspective of the customer, one type of change which the outsourcing arrangement should be structured to facilitate is the reduction or the "descoping" of services, whether due to the poor performance of the service provider, a change in the market, or a change in the strategic direction of the customer. In contrast, the service provider will want to minimize descoping — for among other reasons, because the business case for the service provider may be based on most or all of the scope of services remaining in place. For this reason, the service provider may seek to set a base floor to which the scope can be reduced, beyond which the scope reduction will be deemed to constitute termination for convenience by the customer.
Achieving this flexibility will require setting out pricing in the agreement so that it is broken down by service silo (e.g., distributed computing, help desk) and/or by functional component (e.g., hosting, development). The parties will need to decide on what basis the proportion of the fees should be allocated; for instance, on the basis of the costs of the service provider to provide the applicable service element, or the value to the customer of the service element.3 Note that the service provider will also seek to protect its financial base case by allocating the greatest proportion of the fees to those components which the customer cannot effectively eliminate without terminating the outsourcing arrangement as a whole (for example, the fee for any base licence underlying the outsourcing arrangement).
It is also important not to overlook what effect the scope reductions should have on any early termination fees. The service provider may argue that a material reduction in scope should trigger a partial payment of the termination fees proportionate to the scope reduction,4 payable as of the effective date of such reduction. In contrast, the customer will seek to reduce the termination fees payable for any future termination by an amount proportionate to the amount of the scope reduction; that is, for an outsourcing arrangement with a five-year term, where the scope is reduced by 15% in Contract Year 2, and the customer terminates for convenience in Contract Year 3, the early termination fees payable by the customer would be equal to 85% of the original total.
Needless to say, it is important that the parties set out this granular approach to pricing in advance, in the agreement, to avoid the parties having the discussion as to appropriate fee reductions in what at the time of the reduction could very well be a hostile customer-service provider relationship. We note, however, that where the outsourced services are to be provided in reliance on a "service foundation" which is yet to be built, the actual costs of providing the services, and the allocation of fees between each services silo/component may need to be based on a "best guess" basis. The parties will then need to address with which party this risk should lie.
Addition of Services
Where the customer seeks to add services to the scope of services, two critical factors will need to be addressed: first, under what circumstances can the service provider be permitted to refuse to provide the requested services; and second, what should be the pricing for those additional services.
The outsourcing agreement will seek to define the scope of services in reasonable detail, through means which may include scheduled descriptions, reference to base principles, and non-exhaustive lists of examples of services which are in-scope and out-of-scope. However, it is inevitable that in every outsourcing arrangement there will be a "grey area" as to whether the services are not included within scope,5 and as such constitute "additional" services. These additional services will have to be addressed through change control.
With respect to the first factor — that is, the ability of the service provider to say no — the customer may need to require that the service provider supply requested additional services, where the characteristics of the services and/or the role of such services in the outsourcing arrangement make it impracticable for the customer to retain any other provider to do so. For example, this may be the case where the service provider is performing a series of business functions for the customer, and the additional function which the customer wishes to outsource is so integrally related to the current outsourced functions that it is not realistic to expect that a third party other than the service provider would be able to perform such function. Alternatively, the service provider may have developed unique expertise as the result of a building a system or a business process, which no other provider on the market possesses.
In such circumstances where the requested services are additional services but are so linked to the in-scope services ("linked services"), the second factor — the price for the provision of these additional services — will be critical. The service provider may seek to charge higher rates for and/or overestimate the cost of providing these linked services, but for two entirely different reasons: (a) the service provider has no interest in providing the services in question and is therefore seeking to discourage the customer from requiring the provision of these services; or, (b) the service provider is taking advantage of its positive bargaining position. To the extent possible the customer will seek to control this risk by including appropriate protections in the contract, for example, through requiring that such pricing still meet any most favoured customer pricing requirements in the agreement, or through the benchmarking of such pricing. The service provider, in turn, will need to ensure that it is not forced to use resources to generate excessive numbers of proposals in response to additional service requests, the implementation of which the customer then does not approve. One solution is for the service provider to charge for the preparation of each proposal. This too can present certain disadvantages. Customers can be resistant to such a framework in that it not only imposes barriers to being a flexible, responsive business in the same way that it may have been when the service was provided internally, but can also serve to stifle innovation and the evolution of the services. For the service provider, it can also have the adverse effect of discouraging the customer from approaching the service provider to provide more revenue-generating services.
Amore optimal means by which the customer and the service provider can balance these competing dynamics is through developing a layered proposal process. For example, one model might be structured as follows:
- The service provider may provide, at no cost but within a short turnaround time, a high-level response to a proposal, with an estimate as to the timing and cost of developing the product or providing the service (as well as an estimate as to the cost of providing the second response, described below).
- The customer approves the high-level response, such that the service provider then provides a more detailed, and thus more resource intensive response, with a more exhaustive description of the timing and cost of providing the requested service.
- Where the variance between the first high-level response and the second detailed response is less than a specified percentage, but the customer nevertheless does not authorize the service provider to proceed with the requested service, the customer pays the cost of preparing the second response. If the variance is more than the specified percentage, and the customer does not authorize the service provider to proceed with providing the service, the customer does not pay the cost of the second response.
The above is illustrative only; there are of course many possible permutations.
Controlling Change Control
Finally, it is important to note that one the most consistent complaints of customers is excessive — read, unexpected — additional costs resulting from extensive recourse to change control. This can be a difficult problem to remedy, in that the customer can have equal, if not more, responsibility, for such change control costs, simply through requesting additional services. A customer can seek to control the problem through some or all of the following mechanisms:
- establishing a threshold for the type of "change" which will be referred to change control and thus may be potentially subject to additional charges (for example, the threshold might be only such changes, the implementation of which, individually or in aggregate, would result in a material increase in the incremental costs of the service provider in providing the services);
- establishing a reporting mechanism to allow for tracking of additional costs created through change control, and which sets a threshold for total change control costs in specified period. Where such threshold is exceeded the parties would then be obligated to meet and discuss the reason such threshold was exceeded, and how both parties can seek to reduce such total change control costs. If the amount of excess is significant, this discussion may need to take place at the executive level of each party; or
- in some circumstances, setting what is effectively a "service level" for the total costs of the outsourcing may be appropriate. As in the case of application development ("AD") services, the service level will be breached if the actual spend on the services exceeds budget by a certain specified percentage, except to the extent caused by requests by customer or changes in the specified assumptions. The remedy for breaching this "service level" would have to be settled between the parties.
Changes in Costs as Services Mature
The customer will continue to have the concern of how to ensure that the pricing fairly reflects reductions in the base costs of the service provider over the term of the outsourcing arrangement. Indeed, one article, in suggesting that there might be developing a possible backlash against outsourcing, noted the argument that "long-term contracts hand outsourcers the benefits that customers should rightly get from technological innovation and falling prices".6
Both benchmarking and most favoured customer provisions may provide illusory comfort only: benchmarking because it can be a costly and uncertain exercise which service providers will contend, by seeking to compare the pricing between different outsourcing arrangements, effectively endeavours to compare apples with oranges; and most favoured customer because (a) the term has been generally interpreted to mean "at least as good as" rather than "better than", and (b) where there is a limited or captive market for the product and/or service, every customer of the service provider may be subject to the same high rates.7
It is for this reason that a customer may seek to also include a deemed reduction in the fees over the term, to reflect the following expected changes:
- the declining cost of technology;
- the maturing of the product/services stream, such that high-skill/cost personnel resources can increasingly be supplanted by lower skill/cost personnel as support becomes increasingly ordinary in course; and
- the expansion of the customer base, whether captured in the form of reduced fees to reflect the sharing of the costs over a greater base of customers, or royalties where a proprietary process or technology has been created by the service provider and/or the customer.
Changes in Regulatory Framework
The appropriate allocation between the service provider and the customer of the responsibility for being familiar with, and for the costs of implementing revisions in the services to respond to, changes in any applicable regulatory framework can be a very contentious issue. What allocation is appropriate will widely vary depending on the circumstances. The service provider will argue that the customer should be most familiar with the specific regulatory regime and should therefore be responsible, while the customer may note that to the extent elements of the regime relate exclusively to the outsourced function, the customer will not want to continue to be responsible for apprising itself of regulatory changes. The customer will also note that where the service provider is required to implement such changes to the services for other customers in the sector, the aggregate cost of those changes should be allocated between all of the customers.
One means of sharing the risk of regulatory change between the customer and the service provider is for the service provider to allocate a certain resource commitment to the implementation of such regulatory changes, which commitment is then included as an in-scope service. Regulatory changes that require the service provider to use resources in excess of the resource commitment, however, would be out-of-scope, and thus at the cost of the customer.
Changes in Assumptions: Extraordinary Events
Finally, the customer will seek to protect itself from the effect of "extraordinary events" — that is, an event which results in a change in the scope, nature or volume of the required services (e.g., a pandemic) — by including a provision that, if such an extraordinary event occurs, the customer is permitted to, at its option: (a) suspend and/or obtain a third party to perform certain services for the duration of the extraordinary event; (b) direct the service provider to provide the services in an extraordinary manner (including to perform the services at service levels above or below the agreed service levels for a limited duration); and/or, (c) to the extent and during such period of time that an extraordinary event causes a decrease in services volumes, decrease any agreed minimum volume commitments. Where such a request causes an increase in the service provider’s direct cost of performance of the affected services, the service provider may require that the customer then pay the service provider an amount equal to any such increase; similarly, here the request decreases the service provider’s direct costs, the service provider may credit to the customer the amount of such decrease, to be applied against future fees.
Prior to entering into any outsourcing arrangement, the prospective parties should review each element of the arrangement with a view to answering the following key question: Will this element respond effectively to change during the term of the arrangement? There are few elements more important than pricing, and parties that make a significant investment in ensuring a positive response to this question will reap dividends once the outsourcing commences.
1 For a comprehensive overview of pricing issues generally in outsourcing arrangements, see Outsourcing Transactions: A Practical Guide, edited by C. Ian Kyer and John P. Beardwood, Canada Law Book, Chapter 9, "Pricing and Payment".
2 Such principles, however, could be built into the change control process.
3 Note that the extent to which the pricing for each component is cost-plus or value-based will affect these discussions.
4 Note that the proportion of the fees attributed to the reduced silo and/or component in the fee breakdown will likely form the basis of the calculation of the appropriate proportion of termination fees so payable for that reduction.
5 A customer can address one element of the gray area — that is, ancillary services, or those tasks which, while required to perform the services, are not necessarily specifically enumerated in the Statements of Work — through defining such services as: "any services, functions, responsibilities or tasks not specifically described in this Agreement which are required for, and are incidental, minor or ancillary to, the performance of any of the foregoing", and ensuring that such ancillary services are included in the definition of "Services".
6 SharedXpertise Forums,"2005:transformational outsourcing gets harder"(January 17, 2005), available online at http://www.sharedservicesbpo.com/file/2346/2005-transformational-outsourcing-gets-harder.html.
7 For an overview of the issues regarding the role of benchmarking and most favoured customer provisions in outsourcing arrangements, see Outsourcing Transactions: A Practical Guide, edited by C. Ian Kyer and John P. Beardwood, Canada Law Book, Chapter 10, "Benchmarking and Its Alternatives".
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.