Key issues to consider when outsourcing in times of economic downturn
29 January 2009
More than ever they are looking to protect their profit margins by reducing cost. Some of them are considering restructuring their business or divesting loss-making assets.
In this climate, many companies are considering or have already decided to outsource certain of their business processes. This should allow them to reduce costs, to refocus on core activities and to help them transform their business. Here are some of the issues to consider when negotiating an outsourcing contract in times of economic downturn.
Cost reduction has always been a major driver for many outsourcing deals and is expected to remain so in the light of the tough market conditions. Outsourcing contracts should therefore contain appropriate cost control mechanisms. A decent benchmarking clause may be useful but is often difficult to apply in practice.
For example, it often proves difficult to accurately determine the reference framework against which the outsourced services and their price should be benchmarked. Alternatively, you may consider rewarding the supplier for cost savings realised through an increasingly efficient delivery model. This reward may, for instance, consist of sharing these cost reductions with the supplier.
To make sure that your outsourcing project is run in a cost-efficient manner you may also want to stipulate a "most favoured customer" clause in the contract. In this type of clause the supplier certifies that the price the customer pays will be as low as the best price the supplier charges other customers for the same or similar services. This is often combined with a commitment from the supplier to adjust the price if another customer gets an even better price. These cost control mechanisms are particularly important in long term outsourcing contracts (eg five years or more): if you find out that the supplier's charges are not or no longer competitive and if your contract does not contain cost control mechanisms you may be required to wait for years until the contract expires or pay expensive early termination fees.
Today's economic prospects are uncertain. To ensure companies can react swiftly to changing market conditions, they will have to ensure that their outsourcing contracts offer them as much flexibility as possible. If a company is going through a restructuring or divestment process it will need an outsourcing contract that is sufficiently flexible to accommodate any changes that may result from such process. For instance, the customer may want to change the volume of the services, the geographic scope of the services, the list of affiliates entitled to receive the services, the service levels or any other aspects of the outsourcing relationship.
It is advisable to stipulate that the supplier will keep providing the outsourced services to a divested entity of the customer on the same terms and conditions over a minimum period (eg six months) after the divestiture. It is vital to steer clear of stringent contract terms and to have a clear and workable change control mechanism in place that allows the parties to quickly agree and implement any changes. In times of economic downturn the customer will benefit from a contract that allows them to easily terminate all or part of the outsourced services whether it be for convenience or for cause.
If a customer negotiates a right to terminate the outsourcing contract for convenience, suppliers will often require a mechanism to compensate them for the losses they incur as a result of the termination. This mechanism should be drafted carefully and should be easy to implement to allow the customer to make an accurate cost assessment when considering terminating its outsourcing contract for convenience.
The contract should also require the supplier to prepare and frequently update an "exit plan" describing the supplier's role in transitioning the terminated services to another supplier or back to the customer. Indeed, if the customer has terminated the outsourcing contract, the supplier will typically not be very cooperative in supporting the transition unless bound by clear and enforceable exit commitments that have been agreed on upfront.
Customers often require their outsourcing supplier to comply with the customer's security and disaster recovery standards. Obviously, compliance with these standards can only be expected if the customer has itself implemented appropriate security and disaster recovery standards. Managing risk and compliance internally is therefore a key element to a successful outsourcing relationship. Therefore, prior to entering into an outsourcing contract the customer should conduct due diligence to ensure that its prospective supplier has in place appropriate organisational and technical security measures to protect the customer's confidential information and personal data and to verify whether the prospective supplier's personnel has received adequate training and experience to understand the nature of the outsourced functions and to manage the risks associated with the outsourcing.
In addition, the contract should clearly require the supplier to review its security measures to ensure they have not become outdated. The Supplier should be required to disclose to the customer any development that has or may reasonably be expected to negatively affect the security of the customer's data. Data security measures are all the more important in times of economic downturn as you never know what may happen to your supplier.
In a difficult economic environment, keeping control over the various aspects of the outsourcing relationship is, more than ever, key. Are my supplier's invoices correct? Does my supplier sufficiently protect my data? How big is the risk that my supplier may go bankrupt? What are the cost savings that have really been realised?
Conducting an audit on the supplier may be useful to find a reliable answer to these questions. The outsourcing contract should therefore give the customer sufficient audit rights while at the same time protecting the supplier against any unintended consequences (eg business interruption, disclosure of confidential information relating to other customers, etc) that may result from such audits.
These issues need careful consideration in considering whether to outsource in the current economic climate. Involve your financial, technical and legal people from the very start of the negotiation process and schedule enough time to draft a clear and unambiguous contract. After all, the devil is in the detail…