United States: Incentivizing Performance In Cloud And Outsourcing Contracts: Key Points

Last Updated: August 14 2015
Article by Steve Gold

Defining and incentivizing high-quality performance is often key to the structure of complex service or technology-oriented agreements. In this class of agreements, merely having a performance warranty that answers a yes or no question – in breach or not in breach − just doesn't do the job. To augment those performance warranties, a common approach is to use a "service level agreement" (SLA). The SLA is a familiar and essential feature in information technology-oriented agreements, such as outsourcing, cloud computing, software-as-a-service and the like. When properly structured and negotiated, SLAs can be an effective tool for more nuanced vendor management than a performance warranty alone could afford. This article will catalog some of the best practices for structuring a service level agreement, and discuss elements enterprise corporate counsel can put to use in the IT and service contracts that come across their desk.

  1. Specify Metrics. An initial task in developing an SLA is to specify the metrics that will be utilized. Metrics should meet three criteria. First, they must be objectively measurable without undue overhead or difficulty. While it may be desirable, for example, to measure how long a particular process takes in order to incentivize minimizing that time, if there isn't a way to record when the process starts or stops, that just can't be a useful measurement. Second, they should be truly reflective of performance quality. Third, they should be within the control of the party whose performance is being measured. The last point may seem obvious, but identifying circumstances in which a metric is affected by the actions of others is not always easy.

    Consideration also must be given to the number of metrics that are going to be measured. Part of the objective of an SLA structure is to have a simple, efficient system for contract management. If the number of metrics imposed is too large, the benefits can be lost in the overhead of managing additional infrastructure and process, for example, to measure and monitor each one.
  2. Establish Metric Categories. Typical service level agreements divide the metrics to be measured into two categories: those with financial consequences and those without financial consequences. Terminology varies widely. Often CPI (for "critical performance indicator") is used for metrics with financial consequences and KPI (for "key performance indicator") for those without. (Very confusingly, the term "SLA" is sometimes used to refer to both the CPI metrics and to the entire arrangement. This article uses "SLA" for the arrangement and "CPI" for a metric with financial consequences.) Another term, OLA (for "operating level agreement") is also common and generally designates KPIs that are outside a formal contractual structure.

    A metric under a service level agreement often will have a life cycle of different statuses, as a CPI or KPI. At the initiation of an agreement, both CPIs and KPIs are generally established. When new metrics are added later they typically begin as KPIs for some period before being moved to CPI status, and there is generally a process by which the customer can "promote" or "demote" metrics from one status to another.
  3. Establish Measurement Systems. As noted, an effective CPI needs to be objectively measurable. The service level agreement should specify the manner in which the measurement is to be taken and which party has to bear the cost of maintaining that system and obtaining the periodic measurements. It is fine, for example, to say that an IT system will have a 10 millisecond response time to certain inputs, but most likely another piece of software needs to be licensed, implemented, deployed and maintained, all at some expense, in order to capture that information. In a complex environment with multiple metrics, a service level agreement typically also would provide for changes in measurement systems over time and for the addition of new systems when metrics change.
  4. Set Metric Levels. In addition to defining the metrics to be measured, a service level agreement also specifies what values the vendor is charged with achieving for those metrics. Typically two (sometimes three) levels are specified, each with different financial consequences. Again terminology varies widely, but in general the three levels that are commonly addressed are "minimum," "target" and "bonus" levels. What happens at each of these levels varies and is often the subject of negotiation. However, financial consequences usually result if performance is worse than the minimum level, or if performance is worse than the target level for multiple periods. If a "bonus" level is present – a point often seriously negotiated – it may entitle the vendor to additional compensation or to offset other performance failures.

    In any event, in a service level agreement, a chart just listing these metric levels is never enough. The service level agreement needs to be written to specify how each of these items is to be calculated and what the specific financial consequences are to be. Some SLA formats use the convention of converting all metrics into a scale from 0 to 100 (or expressing them as percentages). As in complicated price formulas in a contract, the key here is providing detailed, step-by-step language so the intended calculation can be performed without disagreement.
  5. Determine Financial Consequences. When a CPI is missed there are financial consequences. Often these are referred to as "penalties," but careful lawyers will structure them as fee adjustments due to the legal principle that penalties in private contracts may not be enforceable by the courts. Typically, therefore, the financial adjustment is referred to as a "service credit."

    The variations on how service credits may be structured and allocated are as numerous as the types of arrangements to which service level agreements are applied, but a typical structure starts with an "at-risk amount" – a maximum dollar value that would be the most a vendor could lose in a given billing period for service-level failures. There is then some mechanism to allocate portions of that amount to individual CPIs, so the particular service credit amount for a given CPI miss is a fraction of the at-risk amount. Though often heavily negotiated, the overall at-risk amount typically is determined as a percentage of the amount being spent under the agreement.

    Importantly, the fraction of the at-risk amount assigned to individual CPIs is often based on more than the total at-risk amount (for example, one-fifth of the at-risk amount assigned to each of 10 CPIs) with the at-risk amount acting as a cap on service credits if there are multiple breaches in a period.

    When a service level agreement has a large number of CPIs and KPIs, it is common to use a point allocation system by which the customer can emphasize and de-emphasize different aspects of performance over the life cycle of the agreement or as vendor performance in different areas becomes more or less problematic. For example, if, in an outsourcing agreement, there were CPIs that measured transaction accuracy and installation time, the customer would be able to put a greater or lesser proportion of the at-risk amount in any reporting period on one activity or the other.
  6. Decide How to Handle Infrequent Occurrences. One twist that often comes up in service level agreements is how to handle metrics that measure infrequently occurring events or events that may have a very low frequency in some measurement periods. For example, if a metric measured how often an IT vendor timely delivered large print jobs, but in some months there were only one or two large print jobs, then a single late delivery would drop the metric down to 50 percent or zero. Of course, if such a possibility is significant, it calls into question whether that metric should be used as a CPI. But if there is good reason to make it a CPI, it would not be uncommon to negotiate some form of contractual relief for the vendor. This may involve aggregating across measurement periods, aggregating with other metrics, or simply excusing the violation.
  7. Avoid Agreements to Agree. In addition to setting what metrics are to be measured, the service level agreement needs to set the values that parties seek to achieve (the target and/or minimum values). While this should seem obvious, all too often the values are left as an "agreement to agree" later, after the contract is signed. Once the contract is signed, each party has strong contradictory incentives in how they would want to set those metrics, so it becomes very difficult to reach the necessary mutual agreement and for those metrics to serve the function of incentivizing quality performance.

    In some instances there are compelling reasons to defer setting the metrics, for example, where the processes being measured will be established only after the contract is in place. In that scenario, it is not unusual to use a baselining process that establishes initial levels of the various metrics and then uses some formula from those to set the going-forward levels. The difficulty then becomes defining a baselining process that cannot be artificially manipulated in order to suppress or inflate the CPI metrics.
  8. Define High Priority Items. Commonly, some subset of CPIs may be designated as higher priority or "critical" and have some additional sanction beyond the service credits associated with them. This might be an augmented amount of the service credit or some other remedy such as contract termination for cause.
  9. Carefully Formulate Automatic Adjustments. Some agreements provide for changes in CPIs over time, often as a mechanism to incentivize continued increases in efficiency and better performance over time. This can be a formula that simply "raises the bar" on the target or minimum metric by some percentage each period, or a more complex formula that takes into account actual performance and requires the vendor to supply improvements over time. Another approach is to require a fee adjustment if the vendor consistently overperforms the required metrics.

    All of these approaches require thoughtful analysis and work best when there is good historical data with which to evaluate trends. Both the vendor and the customer have opportunities to influence how these requirements are applied, by how the initial state is set and how the contract is performed over time.
  10. Use Comprehensive Reporting. An often-overlooked feature of service level agreements is robust reporting and assuring that the measuring and monitoring systems and processes are designed to provide detailed and timely reporting. In a well-crafted service level agreement, reporting terms go beyond the technical aspects of obtaining and sharing data. They also include thoughtful processes, such as meetings and escalations, to address issues and perform appropriate root-cause analysis when a failure or a trend of failures occurs. The goal of SLAs generally is not to obtain or avoid the financial consequences, but rather to serve as a meaningful input to real-world actions to help the parties achieve the purposes of the agreement.
  11. Tailor each SLA to its Services. While the 10 points above have been termed "best practices" in this article, not all the features outlined here will be appropriate in every context. A nine-figure corporate infrastructure IT outsourcing should certainly address each of these items, but a $100,000 social-networking cloud service might be overpowered by an SLA that heeded all the elements described above. Enterprise corporate counsel should be aware of these aspects of SLAs and fit the metric and incentive structure to an appropriate risk-and-benefit analysis of the services to be provided.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions