IT outsourcing customers are increasingly looking for their service providers not just to cut technology costs or improve process efficiency, but to deliver business results. But getting that kind of business value from IT suppliers has proven to be a challenge.
The secret getting technology providers on board with delivering innovation may actually be the terms of the IT outsourcing deals. “Most IT services buyers seek compliance, not improved supplier performance” from their contracts, says Brad Peterson, partner in the Chicago office of law firm Mayer Brown. “That’s all that’s necessary for most it services categories. However, IT buyers can create substantially more value by using incentives to deliver innovation, analytics, data security, mobility, cloud and other fast-changing it services categories.”
We talked to Peterson and Linda Rhodes, partner Mayer Brown’s Washington, D.C. office about what terms can align suppliers with business goals and how to set and enforce service levels that will link supplier profitability to business objectives.
Do most it services buyers use contract terms to improve supplier performance? If not, why not?
Linda Rhodes, partner, Mayer Brown: Many IT services customers use the contract in one or more ways to improve supplier performance, but customers often do not see the full potential of the contract to drive exceptional performance.
Using the contract to drive exceptional performance takes some work on the part of the customer. It is critical that the customer team negotiating the contract really understand the needs of the customer’s business and consider building in multiple incentives—both negative and positive—including the innovative approaches to gain sharing.
Further, the customer team enforcing the contract needs to fully understand and exercise the rights the customer has under the contract and consistently hold the supplier accountable.
Do IT service buyers tend to focus more on disincentives than incentives—to the detriment of the performance of their IT outsourcing arrangements?
Brad Peterson, partner, Mayer Brown: The focus on disincentives is natural. Disincentives help to motivate suppliers to fully comply instead of merely avoid material breach—which is important in all contracts.
Incentives motivate performance beyond compliance, which only delivers value in some contracts. Also, suppliers already have substantial positive incentives outside of the contract, including the chance for referrals and additional awards.
Rhodes: The disincentives are often straightforward and familiar to the customer—for example, a service-level credit for service level defaults, holdbacks until payment milestones are met. It takes some thinking beyond the standard contract terms to create true positive incentives for the supplier.
What sorts of incentives can be embedded into outsourcing contracts to drive better supplier performance?
Rhodes: There are numerous positive and negative incentives that can be used, including the following:
- Ensuring that you have strong general terms in your contract.[Make sure] obligations are clear [around] rights to withhold payment, supplier reporting requirements, audit rights, governance resources. Enforce these rights by holding the supplier accountable through firm correspondence, requiring corrections, withholding payments and collecting credits when available. Require the supplier to indemnify, so legal costs are covered. Exclude certain damages from limitations of liability
- Creating service levels to drive the supplier to meet ongoing service expectations. Use credits to focus on critical business needs and retain flexibility to change, add, modify, and reallocate credits to drive supplier’s focus.
- Building in incentives for projects. Include negative incentives, such as holdbacks and credit, and positive incentives, such as early completion bonuses and gainsharing.
Peterson: You can embed incentives into contract terms by aligning compensation to outcomes and by having exit or other rights triggered by contract events. For best results, start by deciding what business outcomes you want to drive. Then, check whether your provider’s [goals] are aligned with yours by a standard contract structure.
If not, add new compensation terms such as performance credits to correct that misalignment. For example, if a fixed price would allow the provider to increase profit by cutting quality, add a quality metric tied to compensation. A critical best practice is to very carefully draft incentive provisions to avoid gaming and unintended consequences.
How can liability provisions and termination rights be used to drive better performance?
Rhodes: These are complex areas. While there are usually limitations of liability in outsourcing contracts, it is at least as—if not more—important to consider what supplier actions should be outside of the limitations on liability as it is to agree on the limitations themselves. The consequences to the supplier of breaches which are outside of the limitations on liability will be much more powerful in driving supplier behavior.
Termination is not an easy mechanism for a customer to use for many reasons. The customer should be sure to build a strong case for termination, which [can be used] as leverage to drive supplier behavior.
Peterson: If you are using the liability and termination provisions, first put the provider on notice about the breach with firm correspondence and what you ask as a cure. Follow up with subsequent correspondence. By creating a timely written record of your concerns, you show the provider that you are ready to use the liability and termination clauses. The provider thus has good reason to improve performance before you take action under the contract.
How are these various contract terms most effectively enforced if the goal is to improve supplier performance?
Peterson: Another critical best practice is to be ready, willing, and able to give effect to the incentive provision. To be ready, willing and able, you need the tools and data to accurately assess performance; the governance team to review, audit and determine the results; and the management support for following through. You reduce the power of the incentive if you’re willing to be talked out of taking a credit upon a failure or into paying a bonus without a success.
We recommend enforcing these terms consistently with clear correspondence. Treat them as a result of supplier performance, not a punishment or negotiation.
Rhodes: Be diligent. Understand your rights, exercise those rights, hold the supplier accountable, and follow through, follow through, follow through.