A number of long-term outsourcing deals that were signed at the turn of the millennium are showing the strain of age, technological advances and changed circumstances.

Renegotiation of current outsourcing contracts is likely on the agendas of customers, particularly those confronting the realities of the current economic downturn and tightened yearly information technology (IT) and business process outsourcing (BPO) operating budgets. With approximately 20 percent to 40 percent of the revenue of offshore outsourcing providers tied to the financial sector, and with Indian companies currently servicing troubled U.S. auto makers, it is possible that such customers will be insisting on price reductions, potentially influencing the entire offshore outsourcing market.

In addition, with service providers continuing to employ “green” technologies to lower their operating costs, customers may continue nudging providers to pass on the savings to them.

A 2005 Gartner study revealed that nearly 80 percent of outsourcing relationships will be renegotiated at some point during the contract term. Not surprisingly, it has been reported that this past fall, some large American companies have begun negotiating discounts of around 3 percent to 7 percent with their Indian service providers, have shelved new projects, and have also sought to redefine the scope of their service level agreements.

With the myriad of outsourcing providers pursuing a potentially changeable market, there will likely be continued pricing pressures and a tightening scope in the level of services required by customers, and as a result, less-agile service providers may be financially affected during the downturn.

Indeed, this is the type of business climate that tests the mettle of the relationships between a customer’s IT and BPO management and its outsourcing vendors, and if new agreements can be reached, worthwhile, long-term affiliations and quality service can be preserved. From a business point of view, parties to an outsourcing agreement become intertwined and a renegotiation cannot work without mutual cooperation.

This article will discuss strategies for renegotiation of outsourcing agreements and will outline the structured negotiation approach that both the customer and vendor can take to prevent a revisiting of the agreement from turning into relationship failure.

TIME TO RENEGOTIATE?

Companies enter into outsourcing agreements for a variety of reasons, among which include: cost-savings, organizational efficiency and, perhaps most importantly, to better focus on the core objectives of their businesses.

While information technology is usually viewed as vital to an enterprise’s ultimate efficiency, competitiveness and profitability, the economic downturn has, in some cases, slowed the growth in IT and BPO spending for the coming year. Generally speaking, outsourcing customers are seeking to maintain current service levels with fewer resources or, are seeking reductions in service levels and accompanying fee reductions due to the drop in consumer demand. As such, customers are reexamining current arrangements in an effort to achieve additional cost savings, efficiency improvements or innovations.

On the other side, as an incentive for customers to sign outsourcing deals, some service providers offered initial discounts or agreed to make capital investments into emerging technologies. As a result, such providers, expecting to recoup their deferred profits in the long term, may not be amenable to renegotiating price.

When faced with the undeniable reality that changes need to be made, companies and service providers should take immediate action to maintain a positive working relationship instead of making expeditious demands. Management should scrutinize the shortfalls of the current outsourcing arrangement and define the issues ripe for reexamination. Renegotiation might focus on pricing, modification of service levels, or reorganization of processes. Only after an internal evaluation, which consists of consultation among IT and BPO staff and the supported business areas, can management discern significant issues.

EXAMINE THE AGREEMENT

After prioritizing the issues, the dissatisfied customer or service provider must study the outsourcing agreement, which, in some cases, may not have been reviewed since the contract term began, and determine whether the agreement contains enough flexibility that would permit the parties to revisit service levels and prices so that the deal remains competitive throughout the course of the agreement.

Long-term outsourcing agreements often have a contract term of seven to 10 years, and during that time, technologies and market conditions inevitably change. To address such concerns, many outsourcing agreements contain certain change control mechanisms, which allow the parties to alter the scope of the agreement to respond to future fluctuations in the level of required services. For example, a contract might contain formal procedures for handling updates in available technology or upticks or downticks in required service volume, with the parties agreeing to procedures and parameters ahead of time to implement the appropriate changes in service and variations in pricing levels.

One common change control mechanism is a benchmarking clause that allows customers to compare its price levels for particular services to prevailing market prices for similarly situated deals within a particular industry and geographic region. Such analysis is typically performed by an independent third-party benchmarking company and the customer receives a report.

The benchmarkers may also study invoices from the vendor, perhaps uncovering errors that can lead to cost-savings; one benchmarking company reports that approximately 80 percent of all transactions contain errors on their invoices. In short, a benchmarking provision allows the customer to ensure that its pricing structures are competitive within the market, and depending on the language of the agreement, may require the service provider to adjust pricing and service levels accordingly. To the extent the market reflects fee reduction or other concessions granted by vendors due to the economic climate, the customer should be able to take advantage of these.

However, benchmarking services can be costly. A reluctant service provider may also delay in implementing the requested changes or object to the benchmarking process or report, arguing, for example, that the customer’s legacy IT or BPO systems or operational realities incur higher costs and cannot be fairly compared with other outsourcing deals in the marketplace.

Employing contractual tools and fixes, however, should not be a heavy-handed ploy. If the service provider is pressured too much, the relationship might suffer, and practically speaking, the customer might receive less-trained or fewer personnel assigned to its account, resulting in degraded or a lower quality of service.

In contrast, sometimes it is the service provider that is having difficulty due to, among other things, unforeseen problems in serving the customer’s legacy systems or a failure to receive its inflation escalation due to the economic downturn. In such a case, the provider might see if the customer is amenable to renegotiation.

Regardless of which party desires the changes, a party considering asking for a change must arrange for its subject matter experts, financial advisers, IT and BPO experts and legal counsel to internally evaluate the situation to identify problems and arrive at potential solutions. Once the customer’s or vendor’s updated needs are defined and solutions identified, the party should formulate a negotiating stance to address how the current relationship can be recast.

PRESENTING THE SOLUTION

The parties’ executives, along with financial and IT and BPO experts and legal counsel, should draft a detailed presentation to the other party outlining the current concerns and specific IT and BPO issues and competitive limitations of the current agreement and present a proposal for renegotiation. This serves several purposes. It puts the vendor or customer, as the case may be, on notice about the current limitations and perceived inequalities of the agreement. The more time put into defining the issues and preparing a well-reasoned demand, the easier it is to engage the other side. Instead of adopting a scattershot approach, which often escalates into unproductive back-and-forth arguments and finger pointing, a structured negotiating approach generally leads to productive communication that works toward solutions.

Once the parties have agreed on the broad terms of the solution designed to implement the specific service changes or agreed-upon fee reductions, they should formulate a plan. The plan should spell out a course of action that the parties need to take, generally over a 30- to 90-day period, to enact these changes. Depending on various factors, such as the nature and severity of the requested changes or the length of the remaining contract term, the plan can be a modification to the original agreement or an entirely new agreement.

For example, if the original contract is not due to expire for several years, the parties may wish to use the plan to modify the existing agreement. If, however, the original contract is due to expire soon, the parties may prefer to use the new plan as the basis of a new free-standing agreement, allowing the original agreement to expire and, at its expiration, continue the relationship in another form.

There is no hard and fast rule governing the form that the plan takes, and whether it will be a modification or a new agreement normally will be determined on a case-by-case basis.

There can be many ways a modified agreement or recast relationship can be attractive to both parties. For example, if the parties are in the middle of a long-term contract, the customer and vendor may agree to extend the term for two or three additional years in return for discounts in pricing to be effective currently. In addition, the customer and vendor might agree to jointly fund service improvements or investments in new technology that presumably would aid in realizing efficiencies and future cost-savings to be shared.

ADDITIONAL ALTERNATIVES

If the parties fail to agree on a renegotiation and the customer has a right to terminate the agreement for convenience in whole or in part, then the customer might consider a multivendor solution, whereby outsourced services are handed over to multiple, specialized service providers instead of to one major vendor.

Customers may put out certain services for bid to other service providers (which may include the customer’s current provider), assuming that such services can be successfully unbundled from the existing outsourcing agreement with the current service provider and any early termination fees are manageable. However, customers that consider opening up the bidding to multiple vendors would invariably face the additional management costs that are associated with negotiating with and ultimately managing new vendors. Moreover, certain services could be “repatriated” to a U.S. vendor or returned in-house; this occurs more frequently as certain offshore regions experience continued wage inflation that cuts into the cost savings for customers.

If the parties still cannot agree on a feasible renegotiation after serious efforts from both sides, the parties may decide to terminate their business relationship, after which the customer may re-bid the project or return outsourced functions in-house. While some contracts cannot be terminated absent material breach, a well-drafted outsourcing agreement will usually provide a termination for convenience clause, which allows the customer to terminate the agreement without cause, with the customer usually making a final, pre-set payment to the vendor. In most cases, this termination for convenience payment will decrease for each year elapsed during the contract term.

Although this solution may appear, at first blush, to be a fairly easy one, practically speaking, termination requires extraordinary planning. “Unwinding” often can be a difficult job and may require much effort and resources on both sides.

Regardless of the particular IT function that has been outsourced, the customer will need to have an alternative plan in place to ensure a smooth transition and minimal disruption to its business. If a customer does not already have a secondary vendor in place, it will have to quickly and efficiently find a replacement. Selecting and working with a new vendor may require expending large resources both in time and money (e.g., comparing bids and services, the transfer of know-how, and the formation of new relationships).