Contract Outsourcing – How To Formalize & Negotiate It?

Summary:

An outsourcing contract, or contract outsourcing, is a vital legal document that outlines the terms and expectations between a company and the outsourced service provider. Paying close attention to the governance model within the contract is crucial, especially regarding how the Provider will handle any changes that may arise.

To avoid getting trapped in an unfavorable contract with an outsourced provider, it’s best to incorporate an exit plan into the initial agreement. While outsourcing can lead to cost savings, it also presents challenges for both parties involved.

For a successful outsourcing contract, three key objectives should be considered.

• Firstly, clearly define the outsourced services and their alignment with relevant regulations and laws in your country. This ensures transparency and minimizes surprises in the future, allowing both parties to assess the viability of the deal.
• Secondly, ensure that all time frames are explicitly stated and dependent on client demand, and remain open to possible change orders after work has commenced. Avoid making assumptions and maintain flexibility throughout the process.
• Finally, both parties should agree upfront before any financial transactions occur. This mutual acceptance ensures that everyone takes responsibility for their roles in the contract. In the event of any issues down the line, having a clear understanding from the beginning can facilitate a smoother resolution.

Remember, outsourcing is a complex process influenced by various factors such as the required services, project scope, and completion timelines. To determine the best approach for your specific needs, it is highly advisable to seek guidance from an expert in the field. Reach out to an experienced professional today for valuable insights and assistance.

What is an outsourcing contract?

Nowadays, many companies opt for outsourcing as a means to accomplish various tasks without the need for permanent staff. This is where outsourcing contracts play a crucial role. If you’re new to outsourcing and considering IT services from countries like India, China, or Poland, you’re likely to wonder about the specifics of outsourcing contracts. Let’s explore what they entail.

In essence, outsourcing contracts are comprehensive legal documents that outline all the expectations from the outsourcing company. These contracts serve as agreements between the two parties involved in the outsourcing project: the vendor and the buyer. Beyond work expectations, the contracts cover essential aspects such as quality parameters, timelines, pricing, rewards, and more. Additionally, the contract addresses legal matters like intellectual property rights, non-disclosure agreements, and other relevant considerations.

In short, outsourcing contracts provide a detailed roadmap for a successful outsourcing partnership, ensuring both parties understand their roles and responsibilities throughout the process.

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 contract outsourcing?

To achieve significant cost savings, many companies consider outsourcing a wide range of business processes, including IT services. While there are various ways to structure such agreements, a well-thought-out contractual arrangement with appropriate cost-sharing, pass-through mechanisms, and pricing adjustments allows both parties to share certain risks and establish a productive and profitable relationship.

International outsourcing agreements pose challenges for both the vendor and the customer. The vendor is often required to coordinate a worldwide rollout of services with limited time for proper business and legal due diligence before finalizing pricing and implementation. On the other hand, the customer faces potential risks to their performance, costs, and reputation by partnering with an external service provider. Therefore, both parties must carefully assess the perceived value proposition of outsourcing, which promises better and more reliable services at a reduced cost. However, in practice, while customers desire superior services at a lower price, vendors cannot assume liability for every business and legal risk.

In essence, successful outsourcing arrangements require a balanced approach, where risks are shared, and both parties collaborate to ensure a mutually beneficial outcome. Proper evaluation, clear communication, and well-defined contractual terms are essential in establishing a successful and enduring outsourcing partnership.

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 several procedures involved in drafting an outsourcing contract, and we will summarize the most common ones:

1. Request-For-Proposal (RFP): The firm sends an RFP to a selected group of potential outsourcers, seeking information about their company, sector, activities to be outsourced, use of sub-suppliers, contract duration, and transfer of personnel.
2. Specificity and Flexibility: The contract must strike a balance between being specific enough to regulate key aspects and flexible enough to handle unforeseen events without conflicts arising.
3. Performance Evaluation Criteria: The contract should define the criteria for evaluating the outsourcer’s performance and specify the consequences if these criteria are not met. It may also address the use of sub-suppliers and dispute resolution through arbitration.
4. Understanding Supplier Profit: The firm must understand where and how the supplier earns a profit to negotiate effectively. Although pricing is not the only parameter for outsourcing, competitive supplier arrangements often lead to lower prices and reduced margins.
5. Tactics to Win the Contract: Potential outsourcers may use various tactics to win the contract, such as offering low prices for essential services and charging additional costs for contingency services. Suppliers might also initially lower prices and request price adjustments later or impose high withdrawal penalties to deter early contract termination.
6. Comparative Analysis and Due Diligence: Researchers suggest undertaking preventive due diligence for each phase of the outsourcing agreement, especially for offshore outsourcing, due to widespread controversies.
7. Pilot Programs: For the production of goods or service supply, pilot programs may be used, where a limited group of customers test the service under agreed standards. The supplier may offer the service at zero or low cost during the trial period.
8. Transfer of Outsourced Functions: A plan is agreed upon between the two core businesses, outlining the time frame and method for transferring the outsourced functions. Proper involvement of the outsourcer’s personnel and possibly a project team help manage the transfer. Complex activities require more time for a successful transition.
9. Starting with Modest Impact: Companies often begin by outsourcing a function with a limited impact on their economic results, aiming to reduce the negative impact if the performance falls short of expectations.

In conclusion, carefully structuring an outsourcing contract and considering various factors during the negotiation process is crucial for a successful outsourcing relationship. It involves evaluating risks, understanding pricing and profit dynamics, and effectively managing the transfer of functions.

Contract Outsourcing – examples and what should you focus on?

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 considering renegotiating your outsourcing relationship, you are not alone. Renegotiations of outsourcing contracts are increasingly common, with approximately 75% of existing outsourcing relationships being renegotiated at some point during their lifetime. Contrary to what some may think, renegotiations can occur for positive reasons, and they can be initiated by either the service provider or the client.

Change can be beneficial, and if the current outsourcing contract no longer aligns with your evolving circumstances, there is no need to wait for the contract to expire. Taking a proactive approach to renegotiating your outsourcing relationship can lead to improved outcomes for all parties involved.

Here are seven reasons why you should consider renegotiating your outsourcing relationship:

1. Adapting to Changing Circumstances: If your business needs, requirements, or goals have evolved, renegotiating the contract can ensure it aligns with your current situation.
2. Positive Partnership Improvements: Renegotiations can lead to positive changes that enhance the partnership’s effectiveness and success.
3. Easier and Less Risky Than Exiting: Renegotiating the contract is often a more feasible and less risky option than completely terminating the outsourcing arrangement.
4. Improving Vendor Governance: Clear communication and effective governance are vital for successful outsourcing partnerships. Renegotiations can address any breakdown in governance processes.
5. Enhancing Vendor Performance: If the vendor’s performance is lacking, renegotiating the contract can motivate improvements and avoid a breakdown in trust.
6. Win/Win Relationships: Successful partnerships are based on win/win relationships. Entering negotiations with a collaborative mindset is crucial for achieving beneficial outcomes.
7. Time for a Successful Conclusion: Renegotiations require time for thoughtful consideration and should be given sufficient breathing space to reach a successful outcome.

What are the three types of outsourcing contracts?

Understanding the various types of outsourcing contracts is crucial for any outsourcing venture. Let’s explore two prevalent types:

1. Time & Material Outsourcing Contract: This model is ideal for long-term software development projects where it is challenging to estimate time and costs upfront. The contract is based on the required IT services or products and the time taken to complete them. It offers flexibility and continues until the client’s requirements are fulfilled.

Suitable for:

• Projects requiring flexibility and without clearly defined scopes.
• Projects with innovative or complex concepts.
• Projects needing emerging technologies for completion.
• Clients seeking control while collaborating with external teams.

2. Fixed Price/Managed Project Outsourcing Contracts: In this model, the outsourcing company bids on a Request For Proposal (RFP) with a fixed cost for specified services. The contract is well-suited for projects with clearly defined requirements and predetermined costs. It minimizes flexibility but ensures project management and timely delivery.

Suitable for:

• Projects with well-defined and clear requirements.
• Projects with shorter timelines.
• Projects not expected to undergo significant changes post-completion.
• Clients comfortable with relinquishing control under managed projects.

Understanding these contract types will help you select the most appropriate one for your outsourcing needs, be it a flexible time & material contract or a well-defined fixed price contract for managed projects.

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

Outsourcing offers significant benefits but also comes with risks. Some risks, like currency fluctuations, can be addressed through financial-hedging strategies in contracts. However, other risks are harder to anticipate and manage.

The riskiest functions to outsource are those that can disrupt the product or service flow to customers. For instance, outsourcing distribution to an online retailer may lead to delayed deliveries and dissatisfied customers. Outsourcing call-center responsibilities can result in customer complaints and harm the company’s reputation.

The second riskiest type of activity to outsource involves the relationship between the company and its employees. Outsourcing HR functions may impact employee hiring quality, and outsourcing payroll can lead to data breaches and legal issues. Outsourcing software design might hinder organizational innovation.

To mitigate uncertainties, flexibility should be incorporated into outsourcing contracts. One-year reviews and short-term contracts can be costly, and contract variation clauses may not cover all uncertainties. Paying for flexibility may be preferable to rigid performance contracts with penalty clauses that could lead to litigation.

Inevitable uncertainties should be addressed through a conflict resolution process in the contract. Companies may prefer to control their own destiny in situations where uncertainties are likely to arise. Educating companies about the uncertainties in IT contracts can lead to better problem-solving rather than resorting to legal actions. Ultimately, the goal should be to find solutions to contractual problems rather than seeking litigation.

Contracts Outsourcing – A final note

Before finalizing a contract for outsourcing services, both the outsourcing service provider and the outsourcing service buyer must engage in negotiations. It is recommended to create a preliminary contract outline, allowing room for discussions and adjustments. Once the negotiations are complete and the initial draft is thoroughly reviewed, proceed to craft the final version of your outsourcing contract.

During the process of developing your outsourcing contract or IT outsourcing agreement, it is crucial to include all pertinent details in a comprehensive manner to prevent misunderstandings or omissions. A well-crafted outsourcing contract often serves as the cornerstone of a successful outsourcing venture.

Remember, meticulous attention to detail and thorough negotiations will ensure a smooth and beneficial outsourcing partnership.