Contractual Issues and Practical Implications



IT is a popular belief that Offshore outsourcing is in the nature of partnership and strategic alliances (Huff 1991). However, Lacity and Hirschheim (1993) have exposed this as a major outsourcing “myth”. In fact, outsourcing vendors do not share the same profit motives as their customers. Therefore, a tight contract combined with thoroughly executed post-contract governance is the only mechanism to ensure that expectations of the outsourcing customer are met.
There is relatively little literature on systematic and practical treatment of issues relating to outsourcing contracts. Lacity and Hirschheim´s (1993) research represent a major contribution to this field, offering important lessons learnt in contract negotiation. One of the key findings of their research is, that all outsourcing customers agreed that the contract was the number one key issue to a successful outsourcing relationship. This section will give an overview on common types of outsourcing agreements and tries to identify some key contractual issues an outsourcing customer is facing when contracting work out to an offshore IT service provider.
Principal deal structures in offshoring
The four basic deal structures commonly used when offshoring are: Subsidiaries, Joint Ventures, Build Operate Transfer (BOT) and Outsourcing (Eisner 2005). The traditional customer and provider service agreement represents a great number of offshoring arrangements. In traditional outsourcing arrangements, the customer transfers responsibility for certain services to the outsourcing provider. This process usually starts with a request for proposal (RFP) to one or more providers. The outsourcing providers respond to the RFP by describing their capabilities, their service delivery solutions and pricing. The customer then selects one ore more providers and starts to negotiate offshore agreements (Eisner 2005). Involving more than one providers in the RPF process creates competitive pressure among the suppliers and may put the customer into a better bargaining position when starting the negotiation process.
One of the key advantages of traditional offshore outsourcing agreements compared to other deal structures (e.g. Joint Ventures) is the opportunity to lower costs due to the competitive bidding structure of the RFP process. Furthermore, outsourcing providers, typically serving many customers, can maximize efficiencies and lower costs by realizing economies of scale, economies of scope and/or economies of specialization. The latter may also results in the provision of higher service levels.
The key disadvantages of offshore outsourcing agreements are loss of control, loss of flexibility, cost overruns and the risk of misaligned incentives between outsourcing customer and provider (e.i. principal-agent problem) (Eisner 2005, p 121).
Offshore Outsourcing – Common Agreement Structures
Solid contractual provisions are necessary in order to secure the key advantages and mitigate some of the key disadvantages / risks in offshoring to a provider. There are several different agreement structures in offshore outsourcing that may help the outsourcing customer to minimize risks. Eisner (2005) characterizes the following common agreement structures:
  • Pilots: Suppose a company decides to offshore maintenance for a limited set of non-core applications in order to test offshore outsourcing. If the offshore arrangements prove successful, it might gradually increase the scope to more critical applications. Pilots can be used to test offshore outsourcing. Companies oftern use pilot arrangements to assess an outsourcing provider´s capability. When the pilot succeeds, the often move to a full-scale outsourcing arrangement (see below). 
  • Short Terms: Short term agreements contain more detail than pilots. The particular scope of the function or service is committed up front, but the agreement is limited in time. If the arrangement works well, the customer may decide to extend the arrangement.
  • Full-Scale Outsourcing: This model is a more robust and detailed outsourcing arrangement. It includes a precisely defined list of services in scope, a detailed plan for the transition of work and assets to the service provider, a detailed list of service level agreements (SLA: see below for further detail), governance and relationship management provisions, policies and procedures manuals etc.
  • Multiple Suppliers: Some companies prefer to have multiple offshore providers in order to mitigate risk, reduce dependence on a sole provider, maintain competitive pressure and create flexibility. A multiple supplier arrangement works well for project work that can easily be reallocated and can provide a disaster-recovery alternative. The key downside of multiple supplier arrangements is a dramatic increase in governance, management and coordination, resulting in higher control costs. 
Types of outsourcing contracts
Loh and Venkatraman (1991) offer another approach to differentiate between the different types of outsourcing contracts, based on their level of internalization of human resources and technical resources chosen:
Source: Lee (1996)

Three contract types are particularly popular:
1. Complete outsourcing
2. Facility management outsourcing
3. Systems integration outsourcing
Complete outsourcing describes the transfer of the entire IT department of a company, including all or most of the existing IT assets (such as equipment and software) and personnel, from the outsourcing company to the outsourcing vendor (e.g. “The Kodak Effect”). Contracts for this type of outsourcing are usually very voluminous and complicated, as they involve a whole range of assets and related legal issues. Usually these agreements are long term (i.e. 5-10 years) in nature. In the case of complete outsourcing, the outsourcing vendor usually assumes all the risks and responsibilities of providing the outsourcing customer with its IT function on a long-term basis. The degree of internalization of human and technical resources is very low for outsourcing of this type (Pai, Basu 2007, p.34).
In Facility management outsourcing, the outsourcing vendor provides the human resource necessary to operate and manage the outsourcing customer’s equipment and software. In this case, the internalization of technical resources is high while there is a low internalization of human resources (Pai, Basu 2007, p.34).
Systems integration outsourcing “usually involves the contracting of a single outsourcing vendor whose role is to manage the installation and operation of the outsourcing company’s multivendor heterogeneous IT systems in such a way that these systems are integrated and can link with IT systems in other organizations” (Lee 1996, p. 16). The level of internalization of human and technical resources is medium for this type of outsourcing.
Contractual Issues
As mentioned previously, an outsourcing customer cannot expect the outsourcing vendor to act in the best interest of the customer in situations where a conflict of interest arises (Lacity and Hirschheim 1993). Therefore, the written outsourcing contract is the key to a successful outsourcing relationship. Managers need to have a solid understanding of the business and legal issues involved in outsourcing and must be aware of how these issues can be addressed in the contract.
Typically, an outsourcing contract includes a collection of related agreements covering a variety of issues such as service level agreements, transfer of assets, transfer of staff, pricing and payment, and warranty and liability (Lee 1996). These issues are briefly explored below:
Service Level Agreements (SLA)
Once the outsourcing provider is selected and the negotiation of the transfer of functions has been completed, the outsourcing relationship is governed by the so called service level agreements (Pai, Basu 2007, p.36). The service level agreement should precisely describe the types, scope, and nature of all services required. It should specify deadlines and the level of performance (e.g. quality, throughput rate, turnaround time, system availability, etc.) requested by the customer. The service level agreement should also include provisions enabling the outsourcing customer to measure the outsourcing vendor’s contract performance through regular progress meetings and reports (Lee 1996).
"Contractual provisions should be included to penalize the outsourcing vendor financially (e.g. in the form of liquidated damages or service fee reductions) if at any time the vendor delivers a level of service which does not meet with the requirements in the contract. To minimize the chances of future dispute (which could be very costly to the outsourcing customer), the service level agreement should be as comprehensive as possible, including every possible detail, no matter how seemingly trivial or minute" (Lee 1996, p. 17).
Transfer of Assets
Before the outsourcing vendor can perform, certain assets (e.g. computer hardware, licenses, leasing or maintenance contracts etc.) may need to be transferred from the outsourcing customer to the vendor. This is usually handled within a sale agreement. Especially for the transfer of licenses and leasing contracts, independent valuation of these assets by a third party may be needed, which can result in substantial additional costs. The transfer of asset agreement therefore needs to make sure of the correct allocation of all costs involved in carrying out the necessary transfer. In some cases the transfer of assets is suject to taxation, which is the case in the UK. This hidden cost has to be carefully evaluated and taken into account in the overall outsourcing consideration (Lee 1996).
Transfer of Staff
Besides the transfer of assets, many outsourcing agreements also include the transfer or staff from the outsourcing company to the provider. "In some countries (such as the UK), labour regulations require elaborated procedures to be completed before the staff transfer can take place." (Lee 1996 p. 17). If the outsourcing vendor is obliged to take on the transferred employees, he will have to pay the same staff costs. This is a substantial cost factor for the outsourcing vendor and he will most probably try to account for this cost when negotiating the pricing of the outsourcing contract.
From a quality perspective the outsourcing customer might want to ensure the continuity of some key team members who will serve the outsourcing contract and that changes to the key team members should not be made without the permission of the outsourcing customer. These terms should then be added to the contract.
Payment Terms and Pricing
The agreement on pricing and payment terms and schedules is one of the most critical parts in outsourcing arrangements. It is particularly important to make sure that the price agreed covers all services required. Taking into account the sinking cost of technology and a potentially decreasing demand of the customer for the outsourced service in a long-term arrangement, it is recommendable to include in the agreement a mechanism for downward price re-negotiation at a frequency of once every one to two years (Lee 1996).
Warranty and Liability
If the vendor breaches a clause of the service level agreements (e.g. an important delivery deadline is missed), the outsourcing customer can sue the vendor for damage. However, clauses in a contract with an overseas company are worthless if there is no mechanism for enforcing the contract i.e. in jurisdictions where no reciprocal legal arrangements exist, or where it is unrealistic to expect the foreign legal system to cooperate (Pai, Basu 2007). If anything, litigation for contract damages is expensive, time consuming and involves a high level of uncertainty.
Thus, from the outsourcing customer´s point of view it is highly recommendable to include specific terms of express warranty directly into the written contract, for the vendor to indemnify the customer directly (e.g. via penalty payment or a temporary service fee reduction) for any losses, costs (including opportunity costs) and liabilities caused by the vendor´s breach of contract (Lee 1996).

3 comments:

Anonymous said...

Hello.. I like your post. Joint venture outsourcing had also its legal issues.

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Micheal Alexander said...

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