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Outsourcing Contracts: Benchmarking Exercise


Outsourcing Contracts: Benchmarking Exercise

Benchmarking is a sensitive, emotional and, most of the times, a difficult issue for the customer and the outsourcing service provider in the outsourcing process, both during contracting stage as well as when it comes to conducting a benchmarking exercise.


Customer’s perspective of benchmarking: Most customers see benchmarking as an important contractual tool that can help them ensure competitive / favourable pricing in long term outsourcing contracts. As competition between the outsourcing service providers in the market is moving northwards, and technology and digital costs south, majority of customers are increasingly seeking benchmark terms, which has teeth and which require outsourcing service providers to automatically reduce prices during the contract term in line with market pricing trends.


Outsourcing service provider’s perspective of benchmarking: Unsurprisingly on the other hand, Outsourcing service providers view benchmarking differently. While their general perception of the benchmark process has improved in recent years, outsourcing service providers continue to perceive benchmarking in an orthodox manner, with some suspicion, concerned that the benchmarking process is often poorly constructed and adversely implemented, and that it fails to strike a fair balance between the customer and the outsourcing service provider interests.


Through this article, I have attempted to identify the key issues and concerns that should be considered and addressed in the benchmark schedule of the outsourcing contract, and have also recommended approaches that can be taken to achieve a more realistic and balanced benchmarking process.


This article covers the following topics in relation to benchmarking:

  1. Initial considerations whether benchmarking is necessary at all in view of the term of the outsourcing contract.

  2. Appointment of the benchmarker.

  3. Agreeing the benchmark target.

  4. Selecting the benchmark comparison sample.

  5. Agreeing the frequency of the benchmarking exercise.

  6. The mechanism to be followed and the parties' main obligations during the benchmark process.

  7. Consequences of benchmarking exercise and benchmarking report (for example, whether the benchmark is binding or non-binding).


1. Initial considerations

(i) Duration of the Contract

The initial term of the outsourcing contract is one of the foremost important factors for customers to consider in assessing whether to include benchmark provisions in their outsourcing contracts.

The average duration of outsourcing contracts has decreased in recent years. Whereas, in the past, a term of ten or more years was not unusual, in the current trend, an initial term of between three and five years is much more common.

Consequently, and given the time and effort that is often involved in negotiating and agreeing benchmark provisions, customers should, at the commencement of the outsourcing contract negotiations, consider carefully whether formal benchmark rights are required under their outsourcing contracts or not. Customers will normally have run a detailed competitive bidding process and market tested the down-selected outsourcing service provider's charges as part of the competitive bidding process and, for many customers, therefore, formal benchmarking is seen as a "nice to have" rather than an essential in contracts with an initial duration of less than five years. For contracts with an initial duration of five years or more (or in some shorter term contracts where the associated costs of moving to a replacement outsourcing service provider are significant), most customers will generally seek to include an ability to benchmark the outsourcing service provider's charges at regular intervals during the contract duration.


(ii) Status of benchmark results

Another initial consideration, which will have an important bearing on the parties' approach to negotiation of the benchmark provisions in an outsourcing contract, is the status of the benchmarker's report and recommendations.


Customers nowadays are increasingly pressing for benchmark provisions in their outsourcing contracts, which require outsourcing service providers to automatically adjust their charges to match the market or benchmarker’s report and recommendations. This has the potential of being one of the most contentious aspects of the negotiation of the benchmark provisions and, particularly where the amount of any automatic reduction is uncapped, this can be a walkaway position for some outsourcing service providers. It is also likely to lead to protracted negotiations on some of the other key commercial issues relating to the benchmark provisions (such as the benchmark target, for example).


On the other hand, outsourcing service providers, of course, prefer that the benchmark’s report and recommendations are not automatically binding, and that they simply act as a trigger for price re-negotiation. Although this amounts to nothing more than an unenforceable "agreement to agree" in legal terms, some customers consider it to be of value from a commercial standpoint. Because this approach generally leads to an easier negotiation of the other benchmark provisions (and often a more favourable position on those provisions), some customers are prepared to agree to non-binding benchmarking, especially where the services are highly commoditised, and the costs of moving to a replacement outsourcing service provider, in the event that the price re-negotiations are unsuccessful, are low.


(iii) Subject of benchmark

A final issue for early consideration is how much flexibility the customer requires in relation to the services to be benchmarked. This is important in contracts involving the outsourcing of more than one related function or service line or service tower. In this scenario, customers will often wish to retain the ability to benchmark individual functions and service lines. This can be problematic for outsourcing service providers, for a number of reasons. Main among these is that in outsourcing contracts involving the outsourcing of multiple service lines or

service towers, there may be an element of price cross-subsidisation (where the outsourcing service provider accepts a lower profit margin on some service lines or service towers in return for a higher margin on others), and to allow the customer to "cherry pick" the services that are benchmarked would, therefore, result in an inaccurate and unfair comparison.


This is in fact quite a legitimate concern on the outsourcing service provider's part. Customers who wish to retain the flexibility to benchmark by service line or service tower will need to make the outsourcing service provider aware of this early on in contract negotiations, to allow the outsourcing service provider, where possible, to price the service lines or service towers on a standalone basis.

2. Appointing the benchmark adviser

(i) Identify the benchmarker

It is in the interest of both the outsourcing service provider and the customer to appoint an experienced benchmarker with access to the most up-to-date market data. Outsourcing service providers will also wish to ensure the independence of the benchmarker i.e. the benchmarker is in no way related to the customer and also is not a competitor of the outsourcing service provider. The appointment of an independent benchmarker who the parties feel can carry out the benchmark exercise in a fair and even-handed manner is essential if the parties wish to minimise the possibility of dispute at the time a benchmark right is invoked under the outsourcing contract.


The benchmarker is therefore generally appointed by mutual agreement of the customer and the outsourcing service provider. In many respects, it makes most sense to appoint the benchmarker at the time of the benchmarking exercise as this will allow the parties to select the benchmarker with the most up-to-date and accurate data. Customers, however, are understandably concerned that this approach could lead to a delay in the benchmark process, if the parties are unable to agree which benchmarker to use and could potentially be used by the outsourcing service provider as a stalling tactic. To address these concerns, the parties will often agree in the contract, a pre-approved list of potential benchmarkers, acceptable to both parties, from which the customer can choose at the time of the benchmark exercise.


(ii) Terms of appointment

In early outsourcing transactions, it was usual for the customer to instruct and also pay for the benchmarker’s fees. Outsourcing service providers are understandably concerned that this approach affects the benchmarker's independence and objectivity, and due to possible allegiance towards the customer, this may influence the benchmarker's approach to the benchmark exercise and the corresponding conclusions.


For this reason, and also because the outsourcing service provider will derive value from the benchmark exercise in understanding how competitive its pricing is, it is now common practice for the benchmarker to be jointly instructed by customer and outsourcing service provider and, in many cases, for the benchmarker's fees to be shared equally between the parties.

The benchmarker will generally be appointed under a tripartite agreement with the outsourcing service provider and customer, which sets out each of the parties' respective rights, obligations and responsibilities. Outsourcing service providers will want to ensure that the tri-partite agreement contains robust confidentiality terms, limiting the use that the benchmarker can make of any outsourcing service provider pricing information disclosed during the benchmark process. The benchmarker will generally seek to retain the right to add the data it gathers from the outsourcing service provider, on an anonymised basis, to its database of contracts to amongst others, build its market cost estimates, help improve the accuracy of the benchmarker's findings in future benchmarks, agreeing the benchmark target, etc.


3. Benchmark Target

The benchmark target is the price point or “good value” that the outsourcing service provider's charges must meet in order to be considered "competitive" for the purposes of the outsourcing contract. Market practice on this issue continues to evolve, as customers, outsourcing service providers and their advisers learn from earlier outsourcing projects.


Until recently, the benchmark target in many outsourcing contracts has been based on a percentile measurement (with the lowest quartile (25%) being one of the targets most commonly used).


This approach assumes that the benchmarker will have a large number of data points against which to make a comparison. The reality, however, is that the benchmarker will rarely have a sufficient number of data points available to make a percentile target a meaningful measurement. Once the benchmarker has taken into account any relevant normalisation factors to help ensure it is comparing like with like, the size of the comparison sample quickly shrinks. In all but the most commoditised of outsourcings, the benchmarker will generally work from a comparison sample size of between four and ten.


For this reason, most benchmarkers now prefer to work using a benchmark target of the median price of the comparison sample, and this approach is slowly finding its adoption in the benchmark provisions of majority of outsourcing contracts.


There is also an increased recognition among customers that benchmarking is an art, not a science, with the outcome inevitably dependent, to a great extent, on the benchmarker's own judgement, particularly when it comes to selecting the comparison group and applying any normalisation factors. For this reason, the parties will sometimes agree a tolerance threshold to the benchmark target, so that the outsourcing service provider is only required to adjust its charges where they exceed the benchmark target by an agreed percentage (generally 5% of the median).


4. Selecting the comparison sample

Final selection of the comparison sample (peer group and sample size) will normally be left to the benchmarker, and will depend on the data points available to the benchmarker at the time of benchmarking exercise. However, the outsourcing contract will mostly set the parameters for selection of the peer group within which the benchmarker must operate. These parameters will generally include a:

(i) Defined minimum sample size. Definition of the organisations and/or other outsourcing projects that are capable of forming part of the peer group.

(ii) Sample size. Most benchmarkers will generally seek to identify a minimum of four comparators in any benchmark exercise, and this is often the minimum number stipulated in the outsourcing contract. While outsourcing service providers generally prefer to specify a larger number as a minimum, this can be counter-productive for the outsourcing service provider, in that it may pressurize the benchmarker to include within the comparison, sample contracts that are not appropriate comparators.


(iii) Defining the peer group. Approaches to defining the peer group vary, and the following approaches are common:

a. Definition by reference to those service providers that the outsourcing service provider considers to be genuine competitors (in terms of size, scale, geographic footprint and reputation).

b. Definition by reference to the customer organisation with the benchmarker instructed to benchmark against contracts involving customers of a similar size, geographic spread, and service levels of a similar nature to those being provided under the contract in question.


5. Frequency of the benchmark

Outsourcing service providers will typically seek the below two important positions:

  • a "benchmarking holiday" period in the outsourcing contract, post contract signature, during which period, its prices cannot be benchmarked, and

  • to limit the number of benchmark exercises that can be carried out once the benchmarking holiday period is over.


Customers, on the other hand, like to press for maximum flexibility and the right to benchmark as often as they consider necessary during the contract duration.

While this issue can sometimes be contentious, in practice it need not be. As the customer is likely to have benchmarked the outsourcing service provider's pricing as part of the original competitive bidding process post which the outsourcing contract was awarded to the outsourcing service provider, in reality the customer is probably conceding little by agreeing to an initial benchmarking holiday period (provided of course that the period is reasonable).


Following any initial benchmarking holiday period, the frequency with which benchmarking exercises may be carried out will depend, among other things, on:

The duration of the entire outsourcing contract. A right to benchmark only once in a contract of five years or longer is unlikely to be acceptable to most customers.


(i) The complexity (and duration) of the benchmark process.

The duration of the entire benchmark exercise (from benchmarker selection to benchmark report and recommendation) will vary depending on the scope of services and contract concerned. For some benchmarks, it can take as long as six months from triggering the benchmark process in the contract, to finalisation and implementation of the benchmarker's recommendations. In these cases, the customer is unlikely to want to carry out benchmarking annually (particularly when duration is coupled with the costs of the benchmark exercise and prioritization of services against benchmarking exercise). In these cases, customers should

consider if a right to benchmark every couple of years is sufficient as a form of price protection. In other cases, where the market is mature and volatile, the services are commoditized, and prices are dropping quickly (due to technological advancements), annual benchmarking may be more realistic and valuable to the customer.


(ii) Benchmark by service line or service tower.

Where the customer is entitled to benchmark by service line or service tower, it should ensure that any limit on the frequency of benchmarking applies by service line or service tower.


Customers should also bear in mind that, if the outsourcing service provider is agreeing to share the benchmarker's charges, the outsourcing service provider may factor those costs into the service charges the customer must pay. The inclusion of a right to benchmark annually may, therefore, result in an increase in the service charges that the customer must pay to the outsourcing service provider.


6. The benchmark process

(i) Normalisation and price adjustments

One of the key activities that the benchmarker will be required to undertake, to ensure that the benchmark is carried out fairly and objectively, is price normalization. This involves the benchmarker taking into account a range of factors that are likely to influence pricing under the outsourcing contract in question or the contracts within the comparison sample.


While the normalization process and the factors to be taken into account will generally be left to the benchmarker to determine, the parties will often agree in the outsourcing contract a non-exhaustive list of factors that the benchmarker must take into account. These will often include some or all of the following:

a) Service volumes. Greater service volumes are more likely to result in efficiencies, economies of scale and, therefore, more competitive pricing.

b) Service levels and other performance standards. The service levels that the outsourcing service provider must meet may have a direct impact on its costs and therefore its charges. For example, if in an IT outsourcing contract, the customer requires a high availability solution, this may mean the outsourcing service provider providing exceptional back-up arrangements or a dual data centre solution, all of which are likely to have a material impact on the cost of service delivery and cascading to the charges of the outsourcing service provider.

c) Other contract obligations. Other contract obligations may also have a direct impact on the outsourcing service provider's charges. If, for example, the outsourcing service provider has been asked to commit to technology refresh obligations during the term of the outsourcing contract, the outsourcing service provider will make provision for this in its pricing and charges. Any contractual obligations of this nature which have a material impact on charges should be expressly called out in the contract, to assist the benchmaker in understanding any difference between the outsourcing service provider's prices and the market. For the same reason, outsourcing service providers should, where possible, keep a record of any additional costs included in their charges as a result of these contractual commitments.

d) Financial structuring. It has become increasingly common for outsourcing service providers in outsourcing transactions, to finance some or all of the customer's transition costs, and to recover those costs during the term of the outsourcing contract as part of the regular service charges. This has a number of advantages for the customer, including allowing it to achieve cost savings early on in the arrangement , which often it would not otherwise be possible. Where the outsourcing service provider finances transition in this way, it will want to ensure that this is taken into account as part of any benchmark exercise (because the outsourcing service providers' charges in later years of the contract term will be higher than would otherwise have been the case. For outsourcing service providers, it is important to keep a clear record of the costs relating to such financial structuring, so that they can be provided to the benchmarker during the benchmark exercise.


7. Parties’ obligations during the benchmark process

The outsourcing contract should clearly capture the parties' key obligations and responsibilities during the benchmark exercise. These will typically include:

(i) Co-operation and assistance.

The outsourcing contract should include a mandatory obligation on both parties to co-operate with the benchmarker, including by providing the benchmarker with the information it needs to carry out the benchmark exercise. Customers should be cautious of any general qualifications or carve-outs to the information that the outsourcing service provider must provide, as these can give rise to disputes at the time of the benchmark exercise.


For most outsourcing service providers, the key concern will be disclosure of information about its internal costing, as it will not wish to disclose the profit margin it is making under the outsourcing contract. In most cases, this should not be an issue for the customer or the benchmarker, as it is not the outsourcing service provider's margin that is being benchmarked, but the charges overall. If the outsourcing service provider is able to provide the services more efficiently than its competitors, allowing it to make a higher margin, then the outsourcing service provider should not be penalised for doing so if the overall charges meet the benchmark target. An exception to this is "cost-plus" contracts, where the outsourcing service provider's costs and profit margin may well be the subject of the benchmark.


(ii) Adequate resourcing and its availability.

A benchmark exercise will require both parties to devote resources to allow the benchmarker to carry out and complete the benchmark exercise. The contract should include an obligation on both parties to do so, including the appointment by each party of a benchmark point of contact, who will act as primary point of contact to the benchmarker, and co-ordinate the other resources required.

(iii) Timely input.

The benchmark provisions should require both parties to provide any input required (for example, feedback on the benchmarker's draft report) within clearly specified and reasonably realistic timelines.


8. Consequences of benchmarking exercise

(i) Benchmark report: Binding or non-binding?

This is frequently the most sensitive and heavily negotiated aspect of the benchmark provisions of any outsourcing contract. Approaches vary, and much will depend, ultimately, on the parties involved and the relative strength of bargaining positions during contract negotiations.


Customers will, ideally, want the results of the benchmark report to be binding automatically, such that if the outsourcing service provider's charges fail to meet the benchmark target, the outsourcing service provider must automatically reduce its charges to bring them in line with the market. Outsourcing service providers are understandably concerned with this approach, in that it potentially hands over control of the margin they make to a third party. For some outsourcing service providers an uncapped obligation to reduce charges can be a deal-breaker in negotiations.


The outsourcing service provider's preference, of course, is for any benchmark report to be indicative only and subject to governance process, if required. The benchmark report must be used (if at all) to frame discussions or negotiations on pricing, with any adjustment to pricing to be subject to mutual agreement. For many customers an agreement to agree of this nature will be unacceptable, and will not offer the price protection they need to commit to a long- term deal.


There are a number of alternatives to these two positions. These include:

a) Termination rights. One approach that is often proposed (particularly by outsourcing service providers) is for the benchmark results to be non-binding, with a commitment on the parties to reach agreement on an adjustment to the pricing within a set period following finalization of the benchmark report (usually 30 days), and a right, on the customer's part, to terminate the contract or relevant services if the parties are unable to agree a price adjustment within that time period.

b) Capped price adjustments. A more meaningful alternative (from the customer's standpoint) is for the benchmarker's report to be binding subject to a cap. This means that if the outsourcing service provider's prices fail to meet the benchmark target, the outsourcing service provider must adjust its prices to meet the benchmark target, subject to an overall cap on the amount by which it must reduce its pricing.


There are some difficulties with the alternative approach of termination rights for the customer. For example, the parties will need to agree whether this is treated as a termination for convenience, most likely resulting in an early termination charge, or a termination for cause, where no termination charge is payable. Customers will naturally take the view that they should not have to pay an early termination charge, on the basis that termination in this

scenario is not for convenience. However, the likelihood is that if the outsourcing service provider has financed the costs of transition or the run services, it will wish to recover those costs from the customer even if the contract is terminated for this reason. Many outsourcing service providers will, however, agree that any termination charge in this scenario will be limited to recovery of unrecovered investments or deferred charges only, and will not, for example, include any element of lost profit.


For customers, this compromise position remains problematic as they are still faced with a potentially large and prohibitive cost on termination. This is, of course, in addition to the costs the customer will have to incur in transitioning the services from the existing outsourcing service provider either back in-house or to a replacement outsourcing service provider. These costs will often outweigh the savings that the customer would make by transitioning to a cheaper service provider, with the result that any termination right in this scenario is often meaningless in practice. However, a right on the customer's part to terminate, without payment of an early termination charge, may provide useful leverage to ensure a meaningful re-negotiation on price, informed by the benchmark results, in limited circumstances, where the services are highly commoditised and costs of replacing the existing outsourcing service provider are relatively low.


The second alternative approach of capped price adjustments, while not ideal for either party, can serve as a useful compromise position and a zone of possible agreement, providing the customer with some form of binding price protection, while at the same time ensuring that the outsourcing service provider is not locked into a potentially loss-making deal.


(ii) Price adjustments: prospective or retrospective?

A final issue that needs to be addressed in relation to any price adjustment is whether the adjustment is prospective only, or whether it will have retrospective effect.


While many customers will seek to insist on some form of retrospective price adjustment (often to take effect from the start of the benchmark process), this approach causes several issues for outsourcing service providers, including in relation to revenue forecast and potentially revenue recognition.


Prospective only adjustments are however not without risk for the customer. The primary risk with this approach is that the outsourcing service provider will seek to prolong any benchmark exercise with a view to delaying the point at which it is required to make any price adjustment.


To address the problems associated with these two alternatives, one compromise position that is sometimes adopted is for the price adjustment to be prospective only with a long-stop date in the benchmark exercise to which the charges will be retrospectively adjusted in the event that the benchmark exercise runs beyond that date.


Conclusion

Benchmarking remains an important tool for customers for ensuring price protection in longer term outsourcing deals, providing a mechanism to address price drift over the term of the outsourcing contract.

However, the benchmark process is not without its own challenges; it can be complex, resource intensive and, ultimately, is an art, not a science.


Market practice continues to evolve in relation to the commercial aspects of the benchmark provisions, as outsourcing service providers, customers and their advisors learn lessons from earlier and evolving outsourcing deals. There is now a greater recognition within the industry that, in order to create a benchmark process that is workable in practice, it is important that the contract provisions on benchmarking are fair, balanced, and reflect the legitimate concerns of both the outsourcing service provider and the customer.

By: Srijit Mukherjee, Group General Counsel at Node4 Limited

 

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